Capital Budgeting And Working Capital Management Analysis Of Nick Scali Limited

Recommendations on Capital Budgeting Projects

To

Board of Directors

Initech Limited

Date: April 28, 2017-04-28 Subject: Recommendations on capital budgeting projects

We have analysed two different capital budget projects that were undertaken. For making capital budgeting decisions, various techniques need to be applied for making decisions. In this case, we have used net present value technique and payback period technique for making decision in terms of accepting or rejecting capital project.

In first project i.e. of the device part project, we have applied time value of money approach for recommending the selection or rejection of capital project. In assessing the capital project, net present value has been calculated and results have shown positive sign. In this case, net present value is positive which means capital project has been delivering profit to the Initech Limited after mitigating inflation effect also. Net present value uses time value for money concept in its calculation and hence more realistic base for decision making has been provided (Renu, 2014).

Net present value = Present value of cash inflows – Present value of cash outflows

Statement showing calculation of cash inflow from the capital project:

Statement showing net present value of the capital project:

Recommendation: It is recommended to select capital project of establishing new plant and equipment as this will generate $ 460,172 profit in present value terms at the end of project (in all 5 years).

The conveyer system

Recommendation: In this case, there are 3 different systems are under consideration and each has different cost, expected life and annual maintenance cost. Therefore in this case, annual equated cash outflow will be considered for the recommendations. In this case, it can be observed that system B has lowest annually equaled cash outflow i.e. $ 101,944 as compared to other two systems under consideration. Therefore in the basis of above table it can be recommended that system B shall be purchased out of all three different systems in consideration.

Briefly describe a likely “average” risk capital budgeting project for the company

Nick Scali Limited is the business organization that has been engaged in the business off furniture in Australian market. Nick Scali Limited has only business segment of furniture. Since they are engaged in furniture business their average capital budgeting risk is at moderate level. Following are different attributes of capital budgeting project of Nick Scali Limited:

Capital budgeting project: For Nick Scali Limited, capital budgeting project is of establishment of new manufacturing plant in Southern Australia. Possible life = 8 years

Cash flow pattern: Almost systematic as there is moderate or low level capital budgeting risk with Nick Scali Limited.

Investment size: Manufacturing plant will required cash outflow of $ 1,000,000 initially and then at the beginning of year 3 working capital of $ 100,000.

Sensitive variables to NPV: Sensitivity in the capital budgeting technique is the factor that is used to consider possible changes that can take place in terms of net present value calculation. In this case, following are some sensitivity factors that can affect NPV:

Inflation rate: Although NPV considers inflation rate into its calculation but if there is huge change in inflation rate in market, then NPV results may get diluted and affected (Bris, 2015).

Capital Budgeting Task

Change in legal framework: Another issue that affects NPC of the undertaken capital project is change in legal framework or legal compliances applicable on Nick Scali Limited. These changes may result in either favor or against the capital project or business operations of business organizations at macro level (Government, 2011).

Assess the working capital management of your assigned company (cash conversion cycle)

Cash conversion cycle = Inventory outstanding days + Days sale outstanding – Days payables outstanding

(Nick Scali Limited, 2016)

Cash conversion cycle

2015: 57 days + 0.54 days – 77.74 days = -20.20 days

2016: 46.46 days + 0.35 days – 67 days = 20.19 days

(Karanovic and Baresa, 2010)

(a) What does the use of commercial paper suggest about the credit risk of Telstra?

Commercial papers are unsecured way of generating loans from the financial institutions in order to manage the company’s inventories and to meet the short-term day-to-day requirement. This increases the liabilities of the company and also increases the availability of cash in hand with the company. It is always considered that the commercial papers are associated with more risk and have less demand.

The annual report of Telstra Corporation Limited stats that “Our commercial paper is used principally to support working capital and short term liquidity” which means that the company had borrowed money from the financial institutions by the way of commercial papers in order to manage its short term requirements of day to day working capital (Peavler, 2016).

Commercial papers are the way by which the day to day requirement of the capital is managed and with this the working capital of the company works smoothly. By the way of borrowing made through commercial papers the amount that will be generated by the company will be less as compared to the borrowing by other means. There will be generation of liquidity in the company. The cash of the company will be increased by such borrowings.

With the money borrowed through commercial papers the company can also make the repayment of the creditors which already exist in the liabilities of the company. With this the creditors can be reduced at one end. But at the same time the working capital will be miss-managed.

The main credit risk associated with commercial papers is that it is an obligation that is to be repaid by the company. As the company is marinating its day to day working capital requirements by borrowing small amounts then there shall be need of bigger funds as well. There can be a risk of non-repayment of the money borrowed by the way of commercial papers. If the company is unable to repay such money itself than it will be even more difficult for it to repay the amount already borrowed from the creditors.

What asset financing policy does the quote above suggest Telstra may follow?

Telstra Corporation Limited shall follow an “Aggressive Asset Financial Policy”. Under this policy the company will finance a particular part of the current assets with the short term financing. It is observed that the company financing its working capital which is the short term requirement of the company by the way of commercial paper. The company rely more on the short term borrowing than the long term to finance the current assets. Under the aggressive financial policy the company can focus on the particular part of the current asset, which is the day to day requirement of capital in case of Telstra Corporation Limited.

The other financial policies which were not considered were-

Hedging Policy- the policies makes a match of the assets and liabilities according to their time of maturity. The match made can be for short term currents assets with the short term debts of the company and also for the long term current assets with the long term debts of the company. This policy was not considered as the use of commercial papers could not be made in this policy (Gayrat, 2011).

Conservative Policy- this is totally opposite to the aggressive policy. Under this the match making of the long term liabilities is made with the long term financing. It is observed in the study that the company is using commercial papers for financing the short term requirements of funds. Hence, this policy was not considered for the company.

Highly Aggressive Policy- the main focus of this policy is on the financing of the fixed assets of the company. The sources of financials which could manage the fixed assets is discussed in this policy. This is the reason that highly aggressive policy is not suggested to the company.

The aggressive policy of financial assets management is suggested over the rest of the policies to the company as it has raised funds by the way of commercial papers which will be used for the short term requirements of the company. Under the policy suggested the focus of the company can be maintained on the current assets of permanent nature very easily.

References

Bris, M., 2015, Sensitivity Analysis as a Managerial Decision Making tool. Faculty of Economics in Osijek, pp 291-294.

Gayrat Yakhshibaev., 2011, Sources Of Short-Term Finance And Investment Opportunaties. European Journal of Business and Economics, 2(0).

Government, A., 2011, Economic Structure and Performance of the Australian Retail Industry. Productivity Commission Inquiry Report.

Karanovic, G., S, B., & Baresa, S. (2010). Financial Analysis Fundament for Assessment the Value of the Company. UTMS Journal of Economics, vol. 1, no 1, pp 73-84.

Kumar, V., 2011, Debtor Turnover Ratio, 1. Retrieved April 28, 2017, from https://www.svtuition.org/2011/11/debtor-turnover-ratio.html

Limited, Nick Scali., 2016, Nick Scali Limited Annual Report, 2016. Annual report, Nick Scali Limited, Sydney, pp 1-40.

Peavler, R., 2016, What is the inventory turnover ratio and how is it calculated? 1. Retrieved April 28, 2017, from https://www.thebalance.com/what-is-inventory-turnover-ratio-and-calculation-393202

Renu Gulia., 2014, Capital Budgeting Decisions-Review Of Literature. Indian Streams Research Journal, vol. 4, no 3, pp 1-5.

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