Research Proposal: Finance and Financial Management

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a) the projects net present value is a loss of £2,180,988. The IRR is -7%. The project does not pay back, since the viable lifespan of the project is six years. Therefore, the project as presently constituted is not viable. The initial setup cost for the facility of £12 million represents such a significant upfront cost that the project simply cannot generate sufficient revenue to render it viable.

The first assumption is that the £2 million already spent on product development is not taken into consideration. When examining a capital budgeting project, sunk costs should not be incorporated into the calculation. This is because that money has already been spent, and the decision that management is faced with concerns money that has not yet already been spent. Capital budgeting has a strong future orientation.

The second assumption is with regards to the plant space. The £80,000 of rent that the company would forgo is included in the calculation. An opportunity cost such as this should be included in the calculation. My calculations of the taxes from the project also included the opportunity cost, because that income would have been taxable. In other words, the £80,000 in revenue would have been subject to £24,000 had it been earned. Opportunity cost calculations must be on a net basis, not gross. The other opportunity cost that was included was the potential resale of the equipment. If the project goes ahead, that equipment will not be sold, but will be disposed of later for no value. Therefore that opportunity cost must also be included.

There were also a few items that did not represent cash flows. These items include the depreciation on the £12 million investment and the £50,000 in rent that head office attributed to the project. The rent charged is not a cash flow for the project, since the opportunity cost of not renting that space has already been included in the calculation. That rent, however, affects the after-tax cash flow because it increases expenses, lowering the project's tax burden. Depreciation expense will also lower the project's tax burden.

Not included in the calculation was the variable cost of £1.80 per unit. This is the portion of head office costs that has been attributed to the project. This is not counted as a project cash flow, because these costs are not project-specific. They would be paid by the company regardless of whether or not the project proceeded. This also means that they do not represent a project-specific tax benefit, either. The capital budgeting process should ideally incorporate cash flows that are attributable to the project itself.

It was assumed for this project that the 20% of completed goods inventory is attributed to the year in which the goods were produced, rather than sold. For example, year 1 production would be the 300,000 sold in year 1, plus the additional finished goods inventory required for year 2 of 80,000. The year 6 production would therefore be the 400,000 units sold less the 80,000 in the finished goods inventory at the beginning of the year.

The 10% materials that need to be purchased in advance of the coming year were not included in the project's calculations. It was assumed that materials will be purchased on credit, and that the increases in liabilities will be offset by an increase in accounts receivable.

A b) the purpose of a sensitivity analysis is to test the effects on the budget calculations of changes to key variables. Sensitivity analyses are a crucial component of capital budgeting for a couple of reasons. One is that the figures used in the budgeting process are estimates, and thus subject to change. Management needs to know what the impacts of some key changes might be. A project could have a high net present value as calculated, but a minor shift in one variable may render the project unprofitable. The other reason why sensitivity analysis is important is to help management identify ways to improve a project's profitability. For a project such as this one, management can evaluate different price points, or identify that the major impediment to profitability is the £12 million initial cost and realize that if they can cut that figure they can improve the project's outlook dramatically.

For this project I performed a sensitivity analysis on the £12 million initial cost, the discount rate, the price, the sales estimates and the variable costs. The initial cost is a significant impediment to profitability. In order to achieve the company's desired rate of return on this project, that initial cost would need to be reduced to £7.25 million. That represents a reduction of 39.5%. Given that this cost is in the very near-term, the £12 million figure is likely fairly accurate. What this says about the project is that since the company is unlikely to change the initial cost enough to bring the project to the desired rate of return, profitability must be found elsewhere.

A test of the sales estimates reveals that if an extra 100,000 units are produced each year, the project's IRR increases to the 14% hurdle rate. It is unknown if the sales estimates are reasonable at this time, but these increases amount to 33% and 25%, which again points to a lack of viability for this project.

Adjusting the price shows us that an increase to £23 will put the value of the project past the hurdle rate. This represents a 28% increase over the estimated price of the product. This may be something that the market can bear, depending on the product and market conditions. This can be a starting point for further discussion as to how this product can be made profitable. For example, suppose modifications are made that would allow the product to be priced at a premium level. The materials cost may increase to £7 but the selling price goes up to £25. Such a scenario would effectively increase the contribution margin of the product, thereby bringing it into profitability.

The sensitivity analysis can also be used to identify variables that have very little bearing on the project. Reductions in the cost of capital, for example, are not sufficient to bring the project to profitability. This is in large part due to the fact that the initial capital outlay is not discounted, and represents a significant portion of the total cost.

Sensitivity analysis can also be used to measure combinations of variables. It may be feasible, for example, to cut the initial cost by £1 million, and raise the price slightly. From that analysis, even adding in a reduction in the tax rate, we see that the project does not clear the hurdle rate based on minor changes. From performing all of these different sensitivity analyses, we can identify improving the contribution margin as the best way to bring the project to profitability. However, if it requires a series of variables to fall into their best-case scenarios for this project to be viable, then it should not be considered a viable project.

2. a) a price earnings (P/E) ratio measures the value of a company's stock vs. The amount of money that the company is actually earning. In theory, the value of a company is the net present value of its future earnings. Future earnings are calculated based on present earnings and the expected growth rate. The growth rate is applied to the earnings, and then discounted back to present value. The P/E ratio is therefore an indicator of the company's future growth prospects, as determined by the market. The result is that if you have two companies both with earnings of fifty cents per share, the one with the higher growth prospects will have the higher stock price.

One valuation model is the dividend growth model. This is a variation of the P/E model, in that only the dividends are measured to determine stock price. This is recognition of the fact that a share of stock represents an investment, and the value of that investment is the value of the cash flows emanating from it. The underlying theory is that it is the dividends, not the earnings, that comprise the value of the investment. The earnings are related to the value of the company as a whole, and only if their capital structure is 100% equity. Therefore, the dividend discount model is a more realistic measure of the value of the stock, as an investment rather than the value of the company as a whole. The components of the dividend discount model are today's dividend, the payout ratio, the expected dividend growth rate, and the discount rate. The P/E can be used to derive the expected growth rate, since P/E is an indicator of the expected future earnings. With these earning and the payout ratio, the future earnings growth can be extrapolated and used to calculate the NPV.

A b) the four companies I have chosen to analyze are FedEx, Yahoo, Nike and Boeing. The respective P/E ratios are 19.25… [END OF PREVIEW]

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