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Capital Budgeting Process: Pinto Limited

ACC00716 Finance Session 1, 2018

Assessment 3: Business Case Studies 2

This assignment has a 25% weighting in your overall mark for this unit and focuses on content from Weeks 6, 7 and 8. The assignment will be marked out of 25 and marks will be allocated as indicated in the rubric below. Your total assignment submission will consist of a word document that should not exceed 1,000 words (excluding reference list), plus a spreadsheet submission.

The assignment is based on the hypothetical case information below.

Pinto Limited has recently been subject to significant competition from overseas manufacturers with much lower costs. To combat this, Pinto is considering a project that will see it move into a new product market considered riskier than its current operations. The CEO has asked you to undertake a financial analysis of the proposed project and present your recommendations in a short memo. As part of your financial analysis you will calculate NPV, IRR, payback period, discounted payback period and profitability index.

The project requires an upfront investment in plant and equipment of $15 million, which will be depreciated on a straight-line basis over the five-year life of the project. The equipment is not expected to have any significant salvage value at the end of its depreciable life.

Pinto paid $25,000 in fees to consultants for a market analysis related to the project. This analysis predicted sales volume of 200,000 units in the first year, which would grow by 50% per year in years two and three, and fall by 50% in each remaining year as demand wanes. Selling price in the first year is expected to be $75 and grow by 3% each year after that.

Pinto’s operations manager has estimated cost of goods sold for the project will equal 60% of sales revenues and selling, general and administrative expenses directly related to the project (excluding depreciation) will be $1 million in the first year and increase by 5% per year thereafter. The operations manager has not included in his estimates any cost for a project operations base because the plan is to use a building the company already owns. Currently Pinto rents this building to another company for $250,000 per year

The project will require an upfront investment in net working capital equal to 20% of the year 1 sales revenue forecast. This investment in working capital will be fully recovered at the end year 5.

The company has a 10% weighted average cost of capital and is subject to a 30% tax rate.

Required: Prepare (1) a spreadsheet financial analysis of the proposed project and (2) a memo to Pinto’s CEO that briefly explains and justifies your chosen methods and any assumptions made, summarises your findings, and presents your recommendations on the proposed project.



Answer

Introduction

The assignment displays the capital budgeting process for a company. Pinto Limited is considering a project to introduce a new product in the market to meet the competition posed by overseas manufacturer. The product is risky and thus the CEO wants to get the financial analysis of the project to be performed and the recommendation on if the company should go ahead with the project. The CEO provides with basic information on the investment required in the project and the production details. The project is evaluated using the capital budgeting techniques of NPV, IRR, payback period, discounted payback period and profitability index (Cole-Ingait, P., n.d.). An Excel spreadsheet with details calculations is attached along with. 

Net Cash Flows Calculations

The capital budgeting projects are evaluated using the net cash flows from the project. This excludes the non cash expense from being considered. The non cash expense are the accounting entries and do not impact the net worth of the project to the company. Thus the net cash flows from the project are calculated.  The cost of $25,000 spent by Pinto limited on market analysis related to the project is not considered in evaluating the project as it is the sunk cost. The cost is already incurred and is not relevant for the project because the cost will be same whatever the outcome of the analysis be (Garcia, M., n.d.). 

 a. Calculations of Net Income: Net income from operations is calculated for the project as follows:


Year
 012345
Net Income :      
Sales Volume (in units)
200,000 300,000 450,000 225,000 112,500 
Sales price (Per unit)
75 77 80 82 84 
Sales Revenue (in $ millions)
15,000,000 23,175,000 35,805,375 18,439,768 9,496,481 
Taxable income
9,000,000 13,905,000 21,483,225 11,063,861 5,697,888 
General & Admin Expenses
1,000,000 1,050,000 1,102,500 1,157,625 1,215,506 
Depreciation
3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 
Taxable income
2,000,000 5,220,000 10,219,650 3,218,282 (416,914)
   Taxes
600,000 1,566,000 3,065,895 965,485 
After-tax income 1,400,000 3,654,000 7,153,755 2,252,798 (416,914)

The life of the new product is assumed to be 5 years with growth and decline in sales of the units.   Thus the units increase in first three year and then decline in last two years. The growth in sales of units is by 50% from last year. The after tax income  is calculated after considering the depreciation expense as it provides the tax shield and saves cash outflows in form of taxes.  

It has been observed that there is net loss before taxes in the 5th year. Thus no taxes have been considered for that year. 

b. Net cash flows Calculations

The net cash flows from the project are calculated considering the operating cash flows as well as capital investments in the project. The net cash flows are as follows:


Year
 012345







Net Cash Flows:      







capital Investment(15,000,000)




Net Income
1,400,000 3,654,000 7,153,755 2,252,798 (416,914)
Add back Depreciation
3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 
Cash Flows from operations
4,400,000 6,654,000 10,153,755 5,252,798 2,583,086 
CF due to change in net working capital(3,000,000)



3,000,000 
Less: Opportunity Cost
(250,000)(250,000)(250,000)(250,000)(250,000)
Net Cash Flows(18,000,000)4,150,000 6,404,000 9,903,755 5,002,798 5,333,086 


The capital investment is made up front and hence it is considered to be made at time ‘Zero’. The income/cash flows starts after a year of operations and hence at the end of year 1. The cash flows from operations are calculated by adding the back depreciation expense to the income after tax. Depreciation expense is a non cash expense and is an accounting entry. Thus is does not affect the cash flows directly (managementstudyguide.com). The project also requires the working capital investment at the beginning of the project and so they are considered at the time of zero. The working capital is recovered at the end of the project. Thus the time difference value of money is considered for working capital investments.

Opportunity cost considered in the project is the income forgone in order to proceed with the project. Pinto Limited does not take into account the land base for the project because it has its own land. The area is currently rented out for the annual rent of $250,000.  If the company chooses the project it will lose the rental revenue. Hence the opportunity cost of selecting the project (Wilkinson, J., 2013). 

c. Evaluation Parameters

The values parameters on which the parameters are evaluated are as follows:

NPV   5,234,531.8 
IRR20.5%
Payback Period2.75Years
Discounted Pay back period3.44Years
Profitability Index1.71


Analysis of the Project

The project of Pinto Limited is analyzed on the capital budgeting parameters as defined above. The cash flows are discounted at 10% which is the weighted average cost of capital of the company. 

i. NPV: NPV of the project gives the net discounted cash flows of the project. The project should be accepted if NPV is positive. NPV of the project is more than $5million. This means that the project is profitable to the company. 

ii. IRR: IRR is the internal rate of return. It is return provided by the project. The IRR should be more than the WACC of the company. The WACC of Pinto Limited is 10% and the IRR is the project is 20.5%. The IRR is more than WACC and thus the project will give higher to the company. 

iii. Payback period: The time in which the initial investment will be recovered. The simple payback period is 2.75 years and discounted payback period is 3.44 years. The capital investment is completely recovered during the life of the project and thus the projects is feasible.

iv. Profitability Index: It is the ratio of t he PV of net cash inflows to initial investment. The index should be more than 1. The PI of the project is 1.71

Conclusion & Recommendation

It is concluded from the above analysis that the project of new product has positive NPV. The IRR is more than the WACC of the company. The payback period is less than the life of the project and the PI is more than 1. All the parameters indicate that the project is profitable and will increase the net worth of the o company.

Thus it is recommended to Pinot Limited that it should accept the new product project.

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