Q2 2019 Group Assignment
Case Study – Coffee Manufacturing Company
200426 Corporate Finance
Maximising shareholders value is an overriding objective of financial managers. As such, capital budgeting decisions are crucial for adding to firm’s market value and must be considered with great care.
Ross et al. (2017, p. 236) emphasise that
Decisions such as these will determine the nature of firm’s operations and products for years to come, primarily because fixed asset investments are generally long-lived and not easily reversed once they are made.
Definition of the problem
Australian firm - Coffee Manufacturing Company (CMC) – is investigating the feasibility of an investment project proposal. A new and improved coffee machine has been developed in-house and according to CMC’s marketing department it has “many obvious advantages over current market products.” Significant amount of money (circa $2 million) has already been invested in the research and development of this product.
Marketing studies had shown that there was ‘a great demand’ for this coffee machine in the marketplace, the decision to go ahead with manufacturing on face value may seem beneficial. However, this project requires significant investment from the company and it’s not clear if additional value would be created for the company.
The potential investment, therefore, will be critically examined in this report using financial analysis tools in order to determine its viability.
The primary objective of this capital budget/analysis is to determine whether CMC should proceed with its fixed asset investment (namely ‘Grinder Cappuccino Machine’). Our group’s task is to analyse projected future cash flows and decide if the project creates enough value for the client firm (‘CMC’). The analysis is followed by the accept-reject recommendation based on our results.
In this section our group seeks to investigate different methods which are typically used to evaluate a proposed investment. The following methods will be discussed and evaluated for their applicability to this project: Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), Payback Period and Average Accounting Return (AAR).
Discount Cash Flow (DCF) Valuation
The project evaluation is primarily dependent on the future cash flow estimates. Therefore, one of the most challenging parts is to come up with accurate future after-tax cash flows (estimating cash revenues and costs). Excel spreadsheet has been prepared with detailed calculations in order to assist in the decision-making process.
Incremental Cash Flows
When evaluating a proposed investment, only relevant information must be included in the analysis. Relevant cash flows are typically called incremental cash flows. Ross et al. (2017, p. 272) provides the following definition ‘The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project’.
There were some important issues raised in the board meeting that need to be addressed when considering relevant expenditure:
NET PRESENT VALUE (NPV)
The Net Present Value (NPV) method involves estimating the future expected cash flows, discounting them to the present value and then subtracting the cost of the investment. Therefore, NPV is the difference between the market value of an investment and its initial cost. Ross et al. (2017, p. 238) provides the following NPV decision rule ‘An investment should be accepted if the net present value is positive and rejected if it is negative’.
Traditionally, NPV method has been the foundation of fixed investment analysis for many firms. This is due to the fact it is closely aligned with maximising shareholder wealth. In this sense NPV outranks most other methods as it considers the duration of the project and time value money principle.
Shortcomings of this method
As noted by Ross et al. (2017, p. 257) ‘NPV has no serious flaws; it is the preferred decision criterion’. However, for this method to be considered effective, acceptable discount rate and accurate cash flow estimates need to be provided. CMC has been in the business of manufacturing and selling coffee machines since 1965 so we assume their projections are valid.
INTERNAL RATE OF RETURN
The internal rate of return is another measure frequently used within the consultancy industry as it gives insight into what return CMC requires to achieve a zero NPV. The principle rule in this method dictates that an investment is to be accepted if the IRR is greater than the required rate of return. In the case of CMC, a 13% ROR may not match the business risk criteria of the whole corporate entity hence may prove to be an inaccurate measure.
Shortcomings of this method
The cashflow stream of this project is deemed as a “non- conventional cashflow stream”. Beginning years would result in a negative outflow and in later years a positive inflow of cash. In these scenario multiple IRR can be achieved would prove unperceptive when making an investment decision.
In this method, the present value of an investment’s future cashflows is divided by its initial cost. If the profitability index is greater than one, the project should be accepted. This method is widely used as it is a simplified indicator for the cost-benefit of a project.
Shortcomings of this method
Does not provide an exact indication of performance rather it is a scoring indicator which may prove ambiguous to upper management in CMC’s case.
This method calculates the time taken for the initial cost of an investment to be recovered from the after tax net cashflows. An investment is accepted only if its payback period is less than the pre-determined cut off period. Payback period method is widely used because it’s simple and easy to understand.
Shortcomings of this method
Time value of money is ignored completely as there is no discounted factor used. Cash flows after the payback are ignored completely as this approach is more focused on cost recoverability. There was also no acceptable payback period provided by CMC.
AVERAGE ACCOUNTING RETURN (AAR)
As defined by Ross et al. (2017, p. 244) AAR is ‘an investment’s average net income divided by its average book value; also known as accounting rate of return ARR’.
Shortcomings of this method
The AAR method has some significant drawbacks. Most importantly it does not account for the time value of money and it uses net income and book value rather than cash flow. Additionally, in order to assess the AAR, the company must have an internal target average accounting return. CMC did not provide the target value, so this method has been omitted from the project consideration decision.
ESTIMATED CASHFLOW TABLE
|YEAR||CASHFLOW||DISCOUNTED CASHFLOW @ 13%|
NPV at 13% = -$ 39, 394.18 (Reject the project since NPV is Negative)
IRR= 12.447% (Reject the project since IRR is less than required rate of return of 13%)
Payback Period = 5.58 years (Long time to recover initial cost by industry standards)
Profitability Index = 0.97 (Reject the project since PI is less than 1)
Over the last four years CMC has invested a significant amount of money into R&D of its new product - Grinder Cappuccino Machine. The new machine has shown some great potential resulting from its technical advantages and favourable marketing studies. However, when making capital budgeting decision regarding a new project, the future cash flows and benefits must be analysed regardless of the already incurred expenses (sunk costs) or any other positive characteristics. Only relevant information needs to be considered and only the projects that maximise value for the shareholders (positive NPV) must be accepted.
Based on the above results at a required rate of return of 13% (the minimum return investors will accept for investment) CMC makes a minimal loss on the project of $39,394.18 and based on NPV decisions rules the business should reject the project. Initial capital cost would take half the project’s life to be recovered (payback period) which suggest funds will be deployed for 50% of the time which generally does not seem efficient. IRR falls short of the ROR by 0.55% which suggests under this method the business will not meet break-even and achieve sizable return at the same time.
As stated previously, NPV is the most reliable method when determining if a particular project is a good investment. However, it is important to keep in mind that the NPV is only an estimate and assumes that the relevant cash flow data was determined correctly. Ross et al. (2017, p. 256) notes that ‘firms typically use multiple criteria for evaluating a proposal’. In our analysis, other indicators - IRR and Payback Period – also agree with the final NPV result. Consequently, assuming the provided cash flow estimates were accurate, CMC should not proceed with the investment of the Grinder Cappuccino Machine since the project would not facilitate shareholder wealth maximisation.
However, it must be kept in mind, that our report presents only the initial analysis. Given that the NPV is only marginally negative, the firm may wish to consider performing more comprehensive evaluation. The section below is designed to complement our findings and assist management in making their final call on the project.
In order to evaluate the proposed project, we identified the cash flows for this project and performed a capital budgeting analysis in the above extract. However, analysis is based on estimates which can be either high or low. Therefore, there are additional considerations that CMC should consider when making the final decision.
Market conditions may change over the coming years, such as the business competition may increase over the investment duration. Other competitors may develop their technology to produce better automatic coffee machines to competing with CMC, which may cause CMC’s unit sales dramatically reduce. In contrast, if consumer demand in “Capo Machine” keep growing rapidly the product sales will sharply rise. To test this hypothesis, we undertook a sensitivity analysis for unit sales, all variables set constant except unit sales. The Group assumes that the best case for CMC is yearly sales of Capo Machine increases 50 units in each year and the worst case is decreasing 50 sale units per year. The result indicates that under the best case, estimated NPV equals $176348.81 which is positive and IRR=15%>13% by decision rules CMC should accept this project. However, under the worst case, estimated NPV equals -$255137.17 which is negative and IRR=9%<13% CMC should reject this project. Hence, the estimated NPV of this project is especially sensitive to projected unit sales.
Forecasting risk (estimation risk) is the possibility that errors in projected cash flows will lead to incorrect decisions( Ross et al. 2017, pp. 190) .In fact, the degree of forecasting risk is high while the estimated NPV is very sensitive to a variable that is difficult to forecast such as unit sale.. Hence CMC might need further market research before starting the project.
Discount rate is another factor to consider, overtime the discount rate and market risk not only affect projected cash flows but also involves opportunity cost that may incur. From our sensitivity analysis the result demonstrates that if discount rates drop to 11%, the estimated NPV is $108947.04, which is positive and IRR=12.43%>11%, according to decision rules this project is acceptable. However, if the discount rate increase to 15%, the estimated NPV= -$169211.58<0 and IRR=12.46%<15% by decision rules should reject this project. For a long-term project like this Capo Machine, the discount rate has especially high risk that might change in the future, CMC might need further market research as the estimated NPV is significantly sensitive to discount rate.
Furthermore, in the future there are opportunities that managers can exploit to improve the outcome of this project. At present our capital budgeting analysis is static and disregards the possibility of future managerial actions. However, management may put in place contingency planning for changing market conditions. For example, if the Capo Machine is especially popular in the market, CMC management may implement the option to expand production or raise the price per unit.
Other factors such as taxes and regulations should also be considered. The government can greatly influence different industries, in some cases the government might have tax grants for domestic/international businesses and regulations, depending on government policy towards trade. If the government wants to encourage the technology innovation in the coffee machine industry, the government may legislate regulations to benefit the coffee industry. CMC might also consider the consumer demand, if the demand is far higher than supply. In addition, capital procurement is a significant factor for CMC as well. If the coffee machine industry goes through a period that essential materials or parts is in short supply with rising prices, this might cause Capo Machine supply shortage with high cost in that period and affecting the cash flow for the project.
Owen, Edward, Charles and Daniel inherited a small family business from their parent’s John and Mary jones in 2013 and changed its name from jones and sons to jones brothers marble works (JBMW). The business produces high-quality natural stone tiles from limestone, marble and travertine and is located in Brisbane. Soon the JBMW has expanded and is now located on one of two adjoining blocks owned by the business. The other block remains vacant. Owen, the major shareholder (40%) and Managing Director, believes that JBMW to diversify into other products. He said it was time they made use of vacant land. Edward and Charles shared the same view however Daniel, the Accountant was not confident about the expansion and preferred the alternative of selling the vacant land. Owen is of the view that now was not the time to sell as land prices were rising in Brisbane and were projected to double in 10 years time according to market forecasts.
Edward is approached by a Hotel Chain to supply material for renovation and also interior work. Edward finds it a good opportunity to diversify in the interior product lines. The gets a market report from a consultancy firm for $75,000 and gets the project cash flows. On a recent visit to Italy Edward also saw beautiful garden pots in travertine and marble which he believed would add value to their external range. Production of these pots were added as an afterthought to the external range after the market report was completed.
Thus JBMW has 3 options:
However to take an informed decision the capital budgeting is done and Daniel is asked to prepare the detailed project evaluation report using the NPV, IRR and the payback period.
The results of the project evaluation are as follows:
The NPV of the project of expansion to the internal line as well as external lines is $145,276. The NPV is positive.
The IRR of the project is 33%
The payback period is 3.38 Years
It is recommended that the business should sell the land block now for $350,000. This will result in direct addition to the net worth of the business.
If the business keeps the land for 10 years it will have to maintain the land and hence it result in reduction in net worth after 10 years.
If the business expands the new internal and external range. The NPV is $ 145,276. This will be the increase in the net worth of the business in 10 years and the business can sell the land for $700,000 after 10 years.
The present value of land sold for $700,000 after 10 years = $113,074
The total present worth is = $258,350 (145,276+113,074) which is less than $350,000
Thus the highest net worth is if the land is sold now for $350,000