Capital Budgeting Decisions For Initech: Device Parts Expansion And Conveyor System

Net Present Value analysis for Device Parts Expansion

Initech is a producer and wholesaler of electronic parts with a cost of capital of 14% and tax rate of 30%. Company is considering two projects for capital budgeting decision. One is the Device part project and the other is the conveyor system.

Analysis is to be made for both the capital budgeting decisions. The device part project is the project for expansion wherein it has to be decided whether the production should be expanded or not. For taking this decision, I will consider the net present value method. The next proposal is the conveyor system which is to be installed in the company as the existing conveyor system which is beyond repair. We are having three alternate conveyor systems. For taking decision on the system to be installed I will consider the Equivalent Annual Cost Method.

It is a project about the expansion of production into the generation of new mobile devices. For taking the decision whether the project should be started or not I will consider the net present value method of capital budgeting.

Net present value is the most appropriate method for evaluating whether or not investment should be made in a new project. It considers the time value of money. Under net present value method, the net discounted cash flows from the project are calculated. The net discounted cash flows are calculated using projected cash flow from the project discounted at the cost of capital less the initial cash outflow. The project is acceptable if the net present value is positive, otherwise the project should be rejected. (Alkaraan, F., & Northcott, D., 2006)

Net present Value is calculated by subtracting the present value of cash outflow from the present value of cash inflow of the project. A positive net present value indicates the earnings projected to be generated from the project or the investment outlay exceeding the cost anticipated to be invested in the project. The positive Net Present Value indicates the profitability of the project and a negative net present value indicates the net loss from the project. In case of independent projects, the project having positive net present value is only acceptable. In case of mutually exclusive projects, if Net Present Value of all the projects is positive, the project with highest net present value should be accepted. If one or more project has negative net present value and others have positive net present value then the project with highest positive net present value should be selected. However, if in any case, the net present value from all the projects is negative then all the projects should be rejected. (Hendricks, John A., 1983)

Equivalent Annual Cost Method analysis for Conveyor System

From the above analysis, it can be concluded that since the net present value of the project is positive, therefore, the project is viable and should be accepted which means that Initech should expand its production of a part for the new generation of mobile devices.

1. Conveyor System

Initech is required to install a conveyor system as soon as possible because the existing system, which does not have any scrap value, is beyond repair. There are three alternates of conveyor system available which are System A, System B and System C. The initial cost of purchasing and installing each system is given, life of each system is given and the net cash outflow of each system annually is also. We have to choose the best possible alternate i.e. the system which would cost the least comparatively.

For analysing the above situation, Equivalent Annual Cost method of capital budgeting would be most appropriate. Equivalent Annual Cost is the annual cost of operating owning and maintaining an asset over its useful life. This method allows the comparison of the cost of different assets with different useful lives and different cost of purchasing and installing the asset. The equivalent annual cost is calculated by dividing the net present value of the asset by the present value of annuity factor. The following steps are followed under the equivalent annual cost method: (William Parrott, 2015)

Step 1: The net present value of cost of each alternate asset is calculated.

Step 2: Then the equivalent annual cost of each asset is calculated by dividing the net present value by the present value annuity factor and adding the annual cash outflow.

Decision: After applying the above two steps, the decision shall be taken. The asset with the lowest equivalent annual cost shall be chosen.

From the above table, it is clear that the System A has the lowest Equivalent Annual Cost amongst all the three conveyor systems. Thus Conveyor System A should be purchased and installed in the company since it is most cost effective.

I have chosen Mantra Group (MTR) which is engaged in provision of hotel and accommodation related service.

1. The average risk capital budgeting project for the company is to establish a new railway and property project. This would increase the profits of the company and it would help in diversifying the business of the Company. The expected life of the project is 10 to 15 years. Initially huge investment is required and then every year also operating capital requirement would be quite high and the size of the investment would be relatively very high for the company. The NPV shall be most sensitive to the initial capital investment as the initial capital investment of the project is very high and moreover the present value of initial investment is also high as the discounting is not done on the initial outflow of funds. Therefore, the NPV is most sensitive to the initial investment in this case.
2. Cash conversion cycle is a tool used to measure the effectiveness of the management of the company and as a result the overall health of the company. It calculates the frequency with which the cash in hand of the company is converted into accounts payable i.e. the creditors and inventory and then again converted into cash in hand through sales and accounts receivable i.e. the debtors. (Annual Report of MTR, 2016)

It is calculated using the following formula:

Cash Conversion cycle = DIO + DSO – DPO

Where,

DIO = Days Inventory Outstanding which refers to the number of days needed by the company to sell its entire inventory.

DSO = Days Sales Outstanding which refers to the number of days needed by the company to realise cash from sales and the accounts receivables i.e. the debtors.

DPO = Days Payable Outstanding which refers to the number of days which the company takes for paying off its bills for purchases and the accounts payable i.e. the creditors.

Days Inventory Outstanding = (Avg. Inventory/ Cost of Goods Sold) * 365

Days Sales Outstanding = (Avg. Accounts Receivable/Total Credit Sales) * 365

Days Payable Outstanding = (Avg. Accounts Payable/ Cost of Sales) * 365

Commercial paper is a form of security issued in the money market which is issued at discount. Generally, the commercial paper are issued by finance companies and banks but can also be issued by the corporations with strong credit worthiness. The main reason behind issuing commercial paper is that the credit can be availed by the issuer at lower rate without any security. (Ken Johnson, Andrew Edelsberg, Duncan McColl, 2012)

Inclusion of commercial paper in short term borrowings means that the credit risk of Telstra is very low as the commercial paper does not carry any risk and has to be repaid on the date of maturity. (Annual Report of Telstra, 2016)

1. There are three kinds of asset financing policies:

Maturity Matching or Self Liquidating approach: Under this approach, the maturities of assets and liabilities are matched. It minimises the risk of the company to unable to pay off its liabilities on maturity.

Aggressive approach: It is suitable for an aggressive company which finances all of its assets either by long term capital or non-spontaneous credit. It is suitable for firms who are willing to sacrifice safety for earning higher profits.

Conservative Approach: Under this approach only long term loans are used to finance all the assets. It is used by company which is extremely risk averse.

Telstra may follow the aggressive approach for the purpose of asset financing. It would reduce the cost of financing the asset as the short term financing is less expensive than long term credit and would also lead to higher profits. (Helena Suvova, 2007)

Benefits of aggressive approach in comparison to maturity matching and conservative approach:

• The liquidity of the company is lower as the company depends upon the short term credit even for financing its long term assets. This does not the funds being idle and thus saves the interest cost.
• Since the interest cost id saved, the profitability increases.
• As the current assets are very less therefore the asset utilisation ratio of the company is high.

References:

1. Alkaraan, F., & Northcott, D., 2006, “Strategic Capital Investment decision-making: A role for emergent analysis tools? A study of practice in large UK manufacturing companies” British Accounting Review
2. Burns, Richard M., and Joe Walker, 2009, “Capital budgeting Surveys: The Future is Now”, Journal of Applied Finance.
3. Hendricks, John A.,  1983, “Capital Budgeting Practices including inflation adjustments”; Managerial Planning
4. William Parrott, 2015, “Equivalent Annual Costs and Benefits”; Available at: https://www.accaglobal.com/in/en/student/exam-support-resources/fundamentals-exams-study-resources/f9/technical-articles/eac.html
5. Robert Alan Hill, 2013, “Working Capital Management: Theory and Strategy”; Available at: https://202.191.120.147:8020/greenstone/collect/admin-ebooks/index/assoc/HASH0138/43fc5eee.dir/doc.pdf
6. Helena Suvova, 2007, “Working Capital Management”; Available at: https://pef.czu.cz/~dittrich/Financial%20EconomicsFall%202008/Working%20capital%20-%20lecture%2012122007%20students.pdf
7. Gamze Vural, Ahmet Gokhan Sokmen, Emin Huseyin Cetenak, 2012, “Effects of Working Capital Management on Firm’s Performance”; International Journal of Economics and Financial Issues, 2, No. 4, pp. 488-495; Available at: file:///C:/Users/asus/Downloads/312-1050-1-PB.pdf
8. Mantra Group Limited, 2016, “Annual Report”; Available at: https://webcache.googleusercontent.com/search?q=cache:3pDKlbOaKtcJ:ir.mantragroup.com.au/DocumentDownload.ashx%3Fitem%3DkrEgQIfx4U64Kaq0XaQIkA+&cd=2&hl=en&ct=clnk&gl=in
9. Telstra Corporation Limited, 2016, “Annual Report”; Available at: https://www.telstra.com.au/content/dam/tcom/about-us/investors/pdf-e/2016-Annual-Report.pdf
10. Senthil Kumaran, 2015, “Sources of Short-term and Long-term financing for Working Capital”; Available at: https://www.invensis.net/blog/finance-and-accounting/sources-of-short-term-and-long-term-financing-for-working-capital/
11. 2016, “Telstra Commercial Paper Liability (Annual)”; Available at: https://ycharts.com/companies/TLSYY/commercial_paper_annual
12. Ken Johnson, Andrew Edelsberg, Duncan McColl, 2012, “Analyzing Commercial Paper Programs”; Available at: https://www3.ambest.com/ambv/ratingmethodology/OpenPDF.aspx?rc=197660

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