TNA Pty Ltd - Capital Budget Evaluation - Example

Capital budget evaluation of the proposed takeover Name Professor Course Date Section 1 Raising fund to buy a business Every business requires some form of financing at some time. in this case TNA Pty. Ltd., a global leader in food packaging and processing, industry, require funds to purchase a majority interest in a in a small local firm in Vietnam. The firm manufactures equipment for food processing and packaging industry. This firm has a factory in a convenient location close to the ports and transport routes and a loyal and hardworking workforce. Unfortunately, the factory has outdated equipment and a relatively high cost structure and the firm is increasingly falling behind its competitors. However, buying the firm may provide an opportunity for TNA to establish a production facility in the heart of Asia without the problems and lead-time involved in developing a Greenfield facility. Following further enquiries TNA management determine that they could complete the takeover of the Vietnamese company that owns the factory for an investment of $A 10 million, $A 6 million of which would be to purchase 100% of the Vietnamese company and $A 4 million in the form of capital equipment to replace some of the aging factory infrastructure. However, the management of TNA are undecided about their best option for sourcing the $A10 million required for the transaction. This section discusses the various option of saucing the funds to purchase the business, There are a number of options available for TNA management to raise fund to buy the Vietnamese firm. One important thing to notes is that, $10 million is relatively large amount, getting the whole amount from one source may be difficult. Therefore, it is advisable to source small amounts from several alternatives that are available. The alternatives include; Bank loan: as mentioned earlier the amount of money required to buy the Vietnamese firm is quite large. Getting a bank loan is one of the appropriate alternatives that the TNA management can seek. However, it is important to note that banks have strict assessment criteria. Strong business case needs to be presented. The TNA management will also have the task of proving that the loan is a low risk proposition for the bank, for them to approve the loan. Collateral that is equivalent to the loan sort will also be required as security to cover potential loss for the bank. Furthermore, proper documentation of the past performance of the company will be required to prove the case (Taylor, 2007). A good business plan indicates the business objectives, and the strategies to achieve those set objectives. In addition, a business plan needs to include the target markets and ways to expand the markets. The TNA management should be prepared to submit all the necessary documentation to support their application. The bank will need to examine the company’s audited account, as well as those of the Vietnamese firm. In addition, the revenue forecast expected as well as expected cash flow after expenses need to be prepared. Some of the disadvantage of bank loan is that the repayment plan is relatively fixed and that the interests are high. It is important to note that bank loans maybe shorter at lower interest rates, or long-term at higher interest rates. Depending on the business case, the TNA management should negotiate the repayment plan with the banks (Taylor, 2007). Equity funding is another option that the management can seek. This refers to investing personal money in the business by for instance using personal savings, and selling some assets to put up the required capital. Equity funding also include asking for loan from friends and family members. One of the advantages of this method is that it can result in a flexible payment agreement and the finance can become available quickly. However if things do not go as planned, it can result to breaking of the relationships. Thus, it is advisable to set things in a formal way including drafting an agreement. Crowd funding is another alternatives for securing funds for business. It refers to a way of obtaining funding through donation of the money from the public. The money is raised through fundraising websites. To encourage people to support the campaign some incentives and reward can be offered. Crowd funding is a good method where strong networks already exist and where the company want to loyalty before starting. Some of the advantages of raising money through crowd funding are, it give the business the opportunity to interact with the customer, it enable creation of loyal customers, and it gives the business opportunity to get customers feedback while it is still developing. In addition, with this method the ownership of the business does not change. Some of the disadvantages of this method is that there is no guarantee that you will be able to acquire the targeted goal in times (Nawir, & Santoso, 2005) Australian Business angels invest in new and expanding business. The angles can be either business or individuals who are willing to invest in business and risk their capital. Normally they can be involved in the running of the business or assume a mentorship role. The Australian business angles can provide development capital, offer business skills, and contacts that can benefits the business. The main advantage of securing funding from business angle is that they can make investment decision quickly. In addition, when they invest they take part of the risk of the growing business. Private investment network association in Australia provides guideline and opportunity for matching business with private entrepreneurs. Normally the investor has to enter into agreement with the business. It is advisable to hire a qualified lawyer and an accountant when drafting a legal agreement for mutual protection of the contracting parties. Venture fund is another alternative that TNA management can seek for funds. In Australia, the government has set aside a high risk capital directed to new or young businesses with high prospect of growth known as venture capital. The venture capital provides the capital for research and development of a new business ideas, early stage business assistance, as well as late stage business expansion. In addition, the fund provides the capital for financial management of buyouts and buyins of established business. Selling share is another option of acquiring the required funds. For instance, the management can decide to sell 20% of the existing business. This can be done privately or by listing the company in stock exchange. However, worthwhile noting is suitable for large established companies that can manage the cost of setting a successful float. When raising the fund it is important to remember that there are restrictions of raising fund in Australia, especially with the selling of shares. For instance according to section 13 of the cooperation act 2001, a private company can only raise equity finance by offering its share to 1. Existing shareholders 2. Its employees 3. Certain class of investors. These classes include small-scale offer to personal investors, listed companies, a person where no consideration is payable for the share and sophisticated investors, which include high net worth individuals, professional investors, and entities investing more than $ 500,000. Furthermore, the law also restricts on publishing investment opportunities. For example section, 734 restrict on advertisement offers, section 736 provides that unsolicited telephone calls or meetings cannot offer shares. Therefore, it is important to seek proper guidance when seeking finance to ensure that the law is followed (Godwin, & Peterson, 2007). Finally, it is important for managers to remember that the acquired fund will be repaid. Therefore, it should be used for the planned purpose. In the event it is impossible to implement the idea, you need to figure out what to do with the funds, which include refunding the money. Section 2 Capital budget evaluation of the proposed takeover Capital budgeting analysis is a process of evaluating how we invest in capital asserts. Basically, we try to answer whether the future benefit of a project will be large to justify the investment given the risk involved. If TNA take over the Vietnamese firm, the operations are expected to start in mid 2015. It is estimated that the operation will generate revenue of $200000 per month, which translate to $2.4 million per year. They are also confidence of gaining additional food processing and packaging business because of the superiority in the new equipment. The estimated growth in value of sale per year are shown as follow Year 1 Year 2 Year 3 Year 4 Year 5 20% 30% 30% 20% 10% In other words, the revenue will grow as the market grows as shown above. The total costs are assumed to 60% of revenue in the first year and 50% of revenue for subsequent years. The exchange rate at April 20 2014 is 19,739 Vietnamese Dong per Australian dollar and it is assumed that the inflation rate will be 4% higher in Vietnam than Australia for the first year, 3% p.a. higher for the next two years and 2% higher in each of the following three years. Computing the relevant cash flow In capital budgeting analysis, we want to identify the after cash flow associated with the project. We are concerned with the relevant changes in the cash flow once we have invested in the purchase of the new firm (Riahi-Belkaoui, 2011). Some of the factors that are relevant to cash flow include 1. Depreciation: capital assert are subjected to depreciation, depreciation is accounted twice in the calculation of the relevant cash flow. First, depreciation is deduces to calculate the tax paid to the project revenue. Second, depreciation is added back to arrive at cash flow since depreciation is a non-cash item. 2. Working capital: an investment require increase in working capital, thus it is important to consider the net change in working capital associated with the project. 3. Most of capital projects may result in increase to allocated overheads, e.g. computer support service. However, the manner in which these allocations are made may not make a difference at all. This is the reason why we need to assess the impact of the capital project and determine whether these cost are relevant. Moreover, we need to assume the sunk costs. Sunk costs reefers to cost that will not change if we invest on a project. Year 0 1 2 3 4 5 Initial investment 10.milion increase in revenue 20% 30% 30% 20% 10% The expected revenue(m$) 2.4 3.12 4.06 4.87 5.36 The costs 60% 50% 50% 50% 50% 1.44 1.56 2.03 2.435 2.68 Total cash flow ($) 0.96 1.56 2.03 2.4 2.6 This means that we shall receive cash of 0.96, 1.56, 2.03, 2.435, and 2.68 million in year 1, 2, 3, 4, and 5, respectively. Calculating the present value of cash flow So far, we have calculated the relevant cash flow for the project. We can now proceed to calculate the present value of the relevant cash flow. Once we have determined the present value of the relevant cash flow, we will have basis of comparing our initial investment. We shall express both the initial investment and the future cash flow in current values. The net of these two amounts will tell us how much value we will create or lose by investing in the project. Once again, since the firm bought will provide these benefits in future, our main objective are to provide the present value of the project, we will discount the future cash flow of the project in to the present. Discounting means taking the future amounts and finding its value today. Financial management rezones the time value of money because 1. Inflation reduces the value of money over time. for instance $500 today have less value in five years due to rising prices (inflation) 2. Uncertainty in future. This means that although we expect we will receive $ 500 two year from now, a lot can happen between now and that can prevent us from acquiring the expected value. This is referred to as uncertainty 3. Opportunity cost of money. $500 today is worthy more than $ 500 in future since we can invest the money and earn some interest. Determine the discounted present value of cash flow using the discounted rate of 10% PV =cash inflow/future value/(1+r)t Therefore PV =0.96/(1+o.1)+1.56/(1.1)2 +2.03/(1.1)3+2.44/(1.1)4+2.68/(1.1)5=0.872727273+ 1.289256198+1.525169046+1.663137764+1.664069146=7.014359 approximately 7.04 million dollars (this figure will be used for other calculation role) Alternatively We can use the inflation as the discounting rates The expected inflation is 4% in the first year, 3% in the next two years and 2% in the next two years. Therefore the net present value of the cash flow is=0.96/(1+0.041)+ 1.56/(1.03)2 + 2.03/(1.03)3 +2.44/(1.02)4 +2.68/(1.02)5= 0.923076923+ 1.470449618+ 1.857737568+ 2.249563612+ 2.403791982=8.904619704 approximately $8.90millions Calculating the net investment Now we have the current value as $ 7.04 million of the cash flow, we need to compare this to our investment amount. In this case, our initial investment is 10 million. $6million of which will be used to purchase 100% of the Vietnamese company and $A 4 million in form of capital equipment to replace some of the aging factory infrastructure. Given that, the estimated residual value for the equipment at the end of the five years is $200,000. Assuming that TNA used a weighted average cost of capital of 10%, then the net investment can be calculated as follows The net investment is = initial investment-residual value for the equipment=10-2= $A8 million. We can also calculate future value as follows Future values (FV) of the net investment. Future value (FV) refers to the future of the investment. It consist original sum of the money invested and the return in form of the interest. The total sum that TNA is required to invest is 10 million dollars, assuming the return rate of 10% then the future value of the investment can be calculated as follows. FV=V0 (1+r)n where V0is the initial sum invested , r is the interest rate and n is the number of period for which the investment is to receive the interest. r=10, n= five years and V0=10 million Therefore FV=10(1.1)5=10(1.61051)= $16.11 million So far, we have calculated current value of our cash flow as 7.04 million and total net investment as 8 million. The economic criteria for evaluating a capita project Now we have completed our main stages of capital budgeting analysis, including the calculation of the discounted cash flow. The next step is to apply some economic criteria for evaluation of the of the project(HOLLAND, & TORREGROSA, 2008). We shall use the net present value (NPV) criterion to evaluate the project. Net present value is the total net present value of the project. The value represent the total value added or subtracted from the organization, in this case TNA, if it buys the Vietnamese firm. The decision criterion here is, if the net present value is positive, we should proceed and make the investment. If the present net value is negative we should not make the investment. Therefore, in the case of TNA Net investment outflow-the present value of inflow=8-7.04 million = $ 0.96 million In the case of TNA, the net present value is positive. The project should be accepted. In other words, acquiring the Vietnamese firm’s represents a good investment thus TNA should progress and invest in the project (BIERMAN, & SMIDT, 2010). Assuming that only $A7 million was required as initial investment then the net present value would be have been a negative thus project could have been rejected. Net investment outflow-the present value of inflow=5-7.04 million = $ -2.04 million Other economic criterions that can be used include return back period and internal rate of return. Payback refers to the number of years it takes to recovery our net investment. We can use the discounted cash flow to calculate the payback period as follows. Year Cash flow(c) PV factor(f) PV cash flow(c*f) Total to date 1 0.96 0.909090909 0.872727 0.872727 2 1.56 0.826446281 1.289256 2.161983471 3 2.03 0.751314801 1.525169 3.687152517 4 2.435 0.683013455 1.663138 5.350290281 5 2.68 0.620921323 1.664069 7.014359427 Under the discounted payback period we will not receive pay back on the project, that is the present day cash flow never reached our net investment of 8 million. Thus, the project does not pay back in five years. The advantage of using discounted payback period over simple payback period is that it accounts for time value of money (Fleming, Konopaski & Fanning, 2009). It is important to note that a project with negative net present value wills not payback the initial investment. In conclusion, according to the budget evaluation the proposed takeover represent a good investment for TNA. Reference Bierman, H., & Smidt, S. (2010). The capital budgeting decision: economic analysis of investment projects. New York, Macmillan. Fleming, M., Konopaski, K., & Fanning, R. (2009). Evaluation of the accuracy of capital project cost estimates. Olympia, WA, State of Washington Joint Legislative Audit and Review Committee. Godwin, S. R., & Peterson, G. E. (2007). Guide to assessing capital stock condition. Washington, DC, Urban Institute Press. Holland, J., & Torregrosa, D. (2008). Capital budgeting. [Washington, D.C.], Congress of the U.S., Congressional Budget Office. http://purl.access.gpo.gov/GPO/LPS9406 Nawir, A., & Santoso, L. (2005). Mutually Beneficial Company-Community Partnerships in Plantation Development: Emerging Lessons from Indonesia.International Forestry Review. 7, 117-192. Riahi-Belkaoui, A. (2011). Evaluating capital projects. Westport, Conn, Quorum Books. http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=62650 Taylor, P. A. (2013). Trick E-Business Taylor, P. W. 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