Nuances of Managerial Finance - Assignment Example

1) It is the duty of a sales manager to present his superiors all relevant financial information and estimates that are related to a project to the best of his ability. The sales estimates prepared by Ross Butler could have been presented in a matter that was more truthful to the real sales estimates. Since Ross decided to forgo to mention that the sales for the first two years would not reach 100,000 units as stipulated, but 60,000 and 75,000 respectively, his exhibit one was misleading. The fact that Butler did not include the true sales numbers for the first two years and failed to account for the significant additional operating capital requirements in his estimates also placed his credibility on the line. The company would have to incur in an additional $305,000 in operating expenses for the first year, $620,000 for the second year, and 921,000 every year thereafter. This readily showed that his presentation and estimates were ill prepared and in fact did not represent the reality of the true total costs for the new expansion project. As the plant manager, Mr. Butler is required to constantly travel back and forth between the two plants in order to solve day to day problems. His true motivation for the expansion project might just be his desire to simplify his job duties and his self-interest might not be aligned with whats best for the company overall. As mentioned by Faulkner in order to provide a true picture of the true overall costs and financial value of the expansion project, Butler should have included an incremental cash flows analysis as well as the NPV and internal rate of return. Additionally his estimates for sales might be overstated as well as the variable cost rate provided might be too optimistic as well. A better way of determining whether a new project is feasible, we should analyze the market and provide sales estimates for worst case scenario, probable outcome, and best case scenario in order to have a better range of possible profitability levels as well as an estimated probability of each individual scenario becoming reality. This same concept of estimating a range of low, medium, high probabilities should be applied to the companys estimated sales levels as well as the probable variable cost rates that could occur. Additionally since the company is selling a bulk commodity product, it is subject to sales price fluctuations that are not accounted for anywhere in his analysis as well as material cost variations that are not necessarily accounted for in his project analysis. 2) For any firm to enter into any new project or investment, the company is only concerned with the additional incremental cash flows that accepting a project will create. The firm usually divides the incremental cash flows in these three categories (Besley & Brigham): Cash flows that occur at the start of the project- Otherwise known as the initial capital outlay or investment. This category usually includes any additional plant or equipment investment, plant leases, as well as any other financial outlays resulting from accepting the new project. Cash flows which continue throughout the life of the project- The new project will create a stream of periodic revenues as well as utilizing additional costs such as operating capital during the life of the project. The total period net cash flow during each period is accounted under this category. Cash flows that occur as a result of ending the project - Any additional revenues that are created as a result of selling any plant and equipment at the end of the projects life is included on the incremental cash flows calculation. Sugar Lake Refining is currently selling 50,000 barrels for a total of $5,000,000 in revenues. After deducting cost of goods sold and total expenses the currently has $955,357 in net income and $960,357 in net cash flows every period. Since the plant is operating at capacity it cannot add anymore production. The following table presents Sugar Lake Refining income and net cash flows that resulted from their actual sales volume without entering into the plant expansion project: Pre-Project Statement Year XY Sales(50,000 barrels at $100) $5,000,000 Cash Expenses Cost of goods sold(50,000 barrels@$60) $3,000,000 Building lease $100,000 Marketing expenses $87,500 Additional Working Capital $420,000 Depreciation $5,000 Other expenses $50,000 Total expenses $3,662,500 Taxable income $1,337,500 Taxes (40%) $382,143 Net Income $955,357 Add: depreciation $5,000 Net cash Flows $960,357 The next exhibit shows the incremental cash flows for every period resulting from accepting the expansion proposal: New Project Initial Investment Outlay Equipment Required: Cost of New machinery $1,275,000 Book value of old equipment $15,000 Costs of moving and installation $25,000 Total Initial Capital Costs $1,315,000 Incremental Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 Sales $1,000,000 $2,500,000 $5,000,000 $5,000,000 $5,000,000 Sale of Plant and Equipment at book value $500,000 Cash Expenses Cost of goods sold (Incremental sales x variable cost) $595,000 $1,462,500 $2,900,000 $2,900,000 $2,900,000 Building lease $325,000 $325,000 $325,000 $325,000 $325,000 Marketing expenses $200,000 $200,000 $165,500 $165,500 $165,500 Depreciation $136,500 $136,500 $136,500 $136,500 $136,500 Additional Working Capital $305,000 $620,000 $921,000 $921,000 $921,000 Other expenses $300,000 $300,000 $300,000 $300,000 $300,000 Total expenses $1,861,500 $3,044,000 $4,748,000 $4,748,000 $4,748,000 Taxable income -$861,500 -$544,000 $252,000 $252,000 $752,000 Taxes (40%) Deferred tax Deferred tax Deferred tax Net Income -$861,500 -$544,000 $252,000 $252,000 $752,000 Add: depreciation $136,500.00 $136,500.00 $136,500.00 $136,500.00 $136,500.00 Net Incremental Cash flows -$725,000.00 -$407,500.00 $388,500.00 $388,500.00 $888,500.00 Terminal cash Flow Sale of Plant and Equipment at book value $500,000.00 Terminal cash Flow $500,000.00 Since the incremental sales are estimated to be only an additional 10,000 units in year one and 25,000 for year 2 the company incurs severe losses in NI of ($861,500) period 1 and ($544,000) for period 2. Their incremental cash flow is -$725,000 year one and -$407,500 for year 2. From year three and four the incremental cash flows are $388,500 with a net income of $252,000. In year five due to the sale of the plant and equipment there is a terminal cash flow of $500,000 for the last year. As a result, the total the incremental cash flow increases to $888,500 the last year. 3) ` Payback period is determined by the number of years required to recover a new project costs. Although the use of payback period is a popular measure used to determine feasibility of a project, it should be used in combination with other performance measures in order to provide a complete picture. Butler should use the net present value since it easily gauges the feasibility of a new project if the net present value calculation is positive based on the discount rate required or even internal rate of return as a guideline to determine true value of a project and whether the overall investment increases or decreases their shareholders wealth. 4) Net present value should be one of the main indicators in order to prove the feasibility of any project alternative. The Net Present value calculation takes the time value of money under consideration by discounting all of the projects cash flows at the required rate of return. A project is accepted if the actual NPV value is positive. Net present value can be calculated in various ways. An individual can manually use the NPV formula in order to calculate the NPV of each of the successive future cash flows. As we can see it can become rather cumbersome and difficult to calculate since an individual calculation must be made for each and every period NPV= CF 0 + CF /(1+k)^1+CF 2/(1+k)^2+CF n/(1+k)^n k=discount rate, CF= Cash flow n= # of periods The NPV is most easily obtained by utilizing the present value interest factor tables, specifically the “Present value of $1 Due at the end of n periods” table available in the back of any finance book or online. The table provides the factors to calculate he NPV of any cash flow for any number of periods and discount interest rate. NPV= CF 0 + CF1(PVIF k,1) + CF 2(PVIF k,2) + CF3(PVIF k,n) k=discount rate, CF= Cash flow n= # of periods The most common way is to use a financial calculator in order to easily calculate the answer automatically with a few key inputs. IRR -9.943% Discount Rate (i) 15% Period Sum Period NPV Payback Period 0 (1,315,000.00) (1,315,000.00) -1315000 1 (725,000.00) (630,460.00) -2040000 2 (407,500.00) (308,110.75) -2447500 3 388,500.00 255,438.75 -2059000 4 388,500.00 222,144.30 -1670500 5 888,500.00 441,762.20 -782000 Total Net Present Value (1,334,225.50) As we can plainly see that if the project duration is five years the net present value of the project is –$1,334,225.50 and the internal rate of return is actually -9.943%. The project will not be paid back in five years since there is a balance of -$782,000 outstanding at the end of the five year period. NPV (978,375.94) IRR -5.107% Discount Rate (i) 15% Actual Period Sum Payback Period 0 (1,315,000.00) -1315000 1 (725,000.00) -2040000 2 (407,500.00) -2447500 3 388,500.00 -2059000 4 388,500.00 -1670500 5 388,500.00 -1282000 6 388500 -893500 7 388500 -505000 8 888500 383500 9 Payback Period 7.01 Years It would take a total of 7.01 years to payback the project investment under the standard payback method. Even after 8 years the project is still not feasible since the NPV is still almost one million dollars in the red as well as a -5.107% IRR. Discounted Payback Method It would take at least 12.996 years to pay back the investment under discounted payback method. Period Sum 0 (1,315,000.00) 1 (725,000.00) 2 (407,500.00) 3 388,500.00 4 388,500.00 5 388,500.00 6 388500 7 388500 8 388500 9 388500 10 388500 11 388500 12 388500 13 888500 Discounted Payback Period 12.996 Years 5) Based on the net negative net present value of $1,334,225.50 as well as an internal rate of return of -9.943 percent the project is completely unfeasible. The firm will go bankrupt as a result of the new investment. Therefore it is recommended that the project should not go forward, since it is economically unfeasible. Works Cited Besley, Scott, and Eugene Brigham. Essential of Managerial Finance (12th ed.). Forth Worth: The Dryden Press. 2000. Print. Read More