Fast Print Limited Capital Expenditure - Report Example

Executive Summary The report presents the financial appraisal of two investment project: Continue using the existing printing machinery Buy a new printing machinery The financial appraisal of these projects is necessary as the future operations of the company depend on them. The method used for the financial appraisal for these projects is the net present value method which is calculated by discounting the future cash flows by using the cost of capital of the company. The result of the NPV analysis shows that it is financially viable for the company to buy new printing machinery as it has a higher present value of benefits. Background Fast Print Limited has been growing at a rapid pace in the past five years by offering its customers with the printing services which is of unmatched quality. The primary business of the company comprises of the printing of high quality publications such as the annual report of the listed companies and the photographic books for the tourism industry. From a humble beginning to a renowned name in the printing industry, Fast Print Limited has always strived to put the needs of its customer in the priority and offer them services which are in accordance with their demands and the industry practice. The business of the company has been increasing at a rapid pace in the past few years and in order to complete the order of the customers; the company needs some major capital expenditure. This major capital expenditure mainly pertains to the procurement of new printing machinery. The old printing machine of the company is currently five years old and fully depreciated in the books of the company (since it was depreciated on a straight line basis for the past five years). The old machine can still operate and earn some revenue for the company, but it will require some substantial increase in the yearly expenditure in account of repair and maintenance. Other alternative for the company is to purchase new machinery which will significantly enhance the revenue generating capability of the company, but this will require immediate and major capital expenditure. This report analyzes the two options of either continuing using the existing machine or purchasing new machinery. The methods used in the financial appraisal of the two proposals are the net present value method through the discounting of cash flows and the internal rate of return technique. Financial Evaluation Technique used in the financial appraisal Investment appraisal through NPV method and IRR method are both very helpful in order to create financially attractive prospective of any investment decision. A good financial analysis is based on the tradeoff between these two methods. However, practically, the IRR method is used widely in investment appraisal decision. The prime reason behind selecting the IRR method of appraisal is that it is comparatively straightforward and can be used without having a prior experience in capital budgeting. NPV method has certain drawbacks and limitations. Different projects must be assessed at different discount rates because the risk for each project is generally different. The reliability of the NPV based investment appraisal can be as reliable as the discount rate itself. However, in practice, it is very unrealistic to determine different discount rate for different investment proposals. Whereas, IRR uses a single discount rate to evaluate every investment, due to which it is used extensively among the financial analysts. With certain disadvantages, the NPV method comes with several attributes which makes it superior to the IRR method. IRR method of appraisal is for evaluating the financial result of an investment over a short period of time. Moreover, IRR is also ineffective for investments proposals which are a mixture of positive and negative cash flow. For these types of investments, the IRR can be more than one. Another factor which makes the NPV method more reliable than the IRR method is the fact that the discount rate changes several time over the period. The IRR method does not incorporate this fact into calculation and, thus, is not suitable for long term investment appraisal. In NPV method, the discount rate is known and is singular which makes it easier to evaluate the feasibility of the investment. An investment with a negative value represents an unattractive investment whereas a positive value represents otherwise. In IRR method, the rate must be compared to a specified risk rate in order to declare the investment proposal effective or ineffective. In the absence of the predetermined risk rate, the IRR method is of no use. Based on the discussed fact, NPV method of appraising investment is more practical and precise. Financial appraisal Financial appraisal of the two projects through the net present value method has yield the following results: Project NPV Continue using the same machinery $639,159 Buying the new machinery $734,101 It is clear from the above analysis that purchasing the new machinery will bring additional benefit to the company in the form of $ 94,942 which is the difference between the NPV of the two projects. In the financial appraisal of the Project 1 (Continue using the same machinery), it has been considered that the sales per annum will increase at the rate of 5%. For this purpose, the sales in the first year has been taken to be $ 250,000 and there by an increase of 5% is shown subsequently very year. Maintenance in year 1 will be $ 150,000 which will increase at the rate of 15% per annum from there since the machine is old and will require major maintenance. In the financial appraisal of the Project 2 (Buying the new machinery), the sales will increase substantially to $ 800,000. It has been assumed in the financial evaluation that after attaining the full capacity in the third year at $ 800,000, the sale of the company will continue to grow at the previously mentioned rate of 5% per annum. Similarly, it has also been assumed that the variable cost and the maintenance cost in the first two years will be in proportion to the percentage of the full capacity. (I.e., in the year 1 and year 2 the variable cost will be 60% and 80% of the total respectively). Once the full capacity is reached, this cost will stabilize at $ 150,000 for the rest of the time period. Depreciation and gain on disposal are non-cash items, but it is included in the cash flow forecasting because of the tax shield. In addition to that, the interest repayment is not included in the cash flows as it is assumed that the required return of the company of 10% (which is supposed to be the weighted average cost of capital for the company) has already incorporated the cost of debt. Thus, including the interest repayment cash flows in the financial appraisal will be useless as the IRR of these cash flows would be zero. The repayment of the loan will start after five years, thus the repayment of loan is also not included in the cash flow projection. The internal rate of return of the second project which is around 26% is also higher than the company’s required rate of return of 10%. This also shows that the project is financially viable and if the company accepts this project this will bring positive cash flows and changes throughout. Analysis of risk and other factors There are several principal risks that surround the project. Fast Print Limited operates in the printing industry, which is subject to rapid changes in many fields such as standard equipment, and operating procedures. The project under consideration requires a careful estimation of all the relevant costs and revenues; a misjudgment in the forecast will cause an error in the project net present value, which might result in the acceptance of a project which is not financially viable. The initial capital expenditure must be carefully projected. In order to do so, it is of prime importance that the company obtains quotations from several companies in order to project the current market value of the machines. An artificially higher price will put a declining effect on the net present value of the project, and an artificially lower price will cause the opposite. Another risk that is present in the financial appraisal of the project is that the company might not have estimated the correct useful life of the equipment. The printing related hardware and equipment are subject to becoming obsolete at a greater pace as compared to the other kinds, so this risk is present. While making an investment appraisal decision, it is imperative to consider the impact of inflation in the future cash flow. The information provided does not include any relevant information about the price inflation over the three year period, which can significantly impact the expected NPV. The director of the company must also consider the sources from which the financing will be obtained for the investment. Financing decision is significant, as the company would have to pay finance charge to the bank or any other financial institution, and the company must have enough cash flow in the future for the payment of these finance charge. In order to commence any investment venture, the director must receive the approval of the shareholders. Although certain investments might appear to be rewarding and worthwhile to do, they do not receive shareholders’ attention that easily. Shareholders, who are often short-sighted and tend to ignore the long-term feasibility, disapprove the decision of the board based on the fact that the cost of the investment will weaken the financial outlook of the organization in the year of the investment. The directors, while making the investment decision, must consider whether it is of a capital nature or will be reflected in the profit and loss of the company as an expense. Recommendation Based on the financial appraisal, it is recommended that the company should buy the new printing machinery as it is likely to generate positive cash flows for the company and its net present value is greater than the net present value of continuing to use the existing machinery. Appendix I Financial Analysis Continue using the same machinery                 1 2 3 4 5 Particulars Time 0 Year 1 Year 2 Year 3 Year 4 Year 5               Annual Sales   250,000 262,500 275,625 289,406 303,877 Annual operating cost   (150,000) 172,500 (198,375) 228,131 (262,351) Taxable Cash flows   100,000 435,000 77,250 517,538 41,526 Tax @ 28%   (28,000) (121,800) (21,630) (144,911) (11,627) After tax cash flows   72,000 313,200 55,620 372,627 29,898 Discounting factor   0.90909 0.82645 0.75131 0.68301 0.62092 Present Value   65,455 258,843 41,788 254,509 18,565 Total Present Value   639,159                       Buying the new machinery                           Particulars Time 0 Year 1 Year 2 Year 3 Year 4 Year 5               Annual Sales   480,000 640,000 800,000 840,000 882,000 Annual operating cost   (90,000) (120,000) (150,000) (150,000) (150,000) Depreciation   (480,000) (336,000) (235,200) (164,640) (115,248) Gain/(loss) on disposal   - - - - 231,088 Taxable Cash flows   (90,000) 184,000 414,800 525,360 847,840 Tax @ 28%   25,200 (51,520) (116,144) (147,101) (237,395) After tax cash flows   (64,800) 132,480 298,656 378,259 610,445 Add: Depreciation   480,000 336,000 235,200 164,640 115,248 Less: Gain on disposal   - - - - (231,088) Capital Expenditure (1,600,000) - - - - - Sale Proceed - - - - - 500,000 Reduction in inventory 30,000 - - - - - Sale proceed of the existing machinery 150,000 - - - - - Total Net cash flows (1,420,000) 415,200 468,480 533,856 542,899 994,605 Discounting factor 1 0.90909 0.82645 0.75131 0.68301 0.62092 Present Value (1,420,000) 377,455 387,174 401,094 370,807 617,571 Net Present Value 734,101           IRR 26%           Appendix II References Financialmodelingguide.com (2007). Capital Budgeting and the Advantages and Disadvantages of IRR and NPV | Financial Modeling Guide. [Online] Available at: http://www.financialmodelingguide.com/valuation-concepts/capital-budgeting-irr-npv/ [Accessed: 14 Nov 2012]. Investopedia.com (2012). Internal Rate Of Return: An Inside Look. [Online] Available at: http://www.investopedia.com/articles/07/internal_rate_return.asp [Accessed: 14 Nov 2012]. Investopedia.com (2012). Net Present Value (NPV) Definition | Investopedia. [Online] Available at: http://www.investopedia.com/terms/n/npv.asp [Accessed: 14 Nov 2012]. Investopedia.com (2012). Which is a better measure for capital budgeting, IRR or NPV?. [Online] Available at: http://www.investopedia.com/ask/answers/05/irrvsnpvcapitalbudgeting.asp [Accessed: 14 Nov 2012]. Langfield-Smith, K., Thorne, H. & Hilton, R. (2012). Management Accounting 6E. 6th ed. McGraw-Hill. Rfs.oxfordjournals.org (2004). Why the NPV Criterion does not Maximize NPV. [Online] Available at: http://rfs.oxfordjournals.org/content/17/1/239.short [Accessed: 14 Nov 2012]. Read More