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Runwell Corporation - Capital Budgeting report ...

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Runwell Corporation Capital Budgeting report

Executive Summary Taking in to account the fact that carbon emissions are a common issue discussed in society the demand for environmentally friendly vehicles will be high in the future, particularly when laws and regulations are introduced prohibiting carbon emitting cars. The proposal to introduce a new line of vehicle parts for environmental protection against carbon emission is a necessary project not only for Runwell Corporation but for society as well. Cash flow analysis, based on contracted volume of sales, showed that: Net Present Value (NPV) for an eight year contract is $529,793, deeming the project profitable. Internal Rate of Return (IRR) is 22% higher than the Weighted Average Cost of Capital (WACC) (14%). The WACC is a required return on investments that have the same risks as existing operations (Ross 555). The discounted rate of return should be increased for the new contract, due to increased project risks and unexpected growth in car manufacturing technology. Discounted Payback Period is 6 years which is greater than the required period, however it is not concrete decision criteria as it is ignores cash flows beyond the discounted payback period and cannot indicate increase of company value (Ross 211). Sale of contract to another compliant company for $200,000 is not profitable as NPV is much higher. To increase the length of the project from eight to ten years, will increase NPV from $530K to $726K or by 36%. This option should be seriously considered and will be highly recommended if a successful agreement can be made between Runwell and a contracted company.

1 TABLE OF CONTENTS 2

Introduction.............................................................................................................3

3

Project Analysis.......................................................................................................3 3.1

Plant and Equipment.........................................................................................3

3.2

Calculation of Net Present Value and Internal Rate of Return..........................4

3.3

Discounted payback period...............................................................................5

3.4

Option to extend the Project..............................................................................6

4

Summary of Project Analysis..................................................................................7

5

Conclusion...............................................................................................................7

6

References...............................................................................................................8

2 INTRODUCTION To determine the profitability of capital, a cash flow analysis is the most useful option. It involves the evaluation and comparison of two flows: the cash outflows and the cash inflows. The cash outflows mainly consist of the initial capital funds allocated to an investment project as well as the capital expenditures throughout the life of assets. The cash inflows consist primarily of estimates of the returns expected on an investment project, this also include the depreciation of the productive assets and their residual values. (Alhabeeb 205)

3 PROJECT ANALYSIS To analyse a proposal regarding a new line of vehicle parts, three steps will be used (Ross 229):  Calculating the tax effect  Calculation of cash flows  Discounting the cash to make the decision

3.1 PLANT

AND

EQUIPMENT

To be able to analyse a new project, first of all the cost of a new plant and equipment (P&E) must be calculated. To start the new production line, renovation of one existing section of the factory is required. The total renovation cost will be capitalized. A local distributor of a Japanese company can immediately supply all required parts and accessories for the new P&E, installation, transportation and import duty cost are to be incurred.

Depreciation of new P&E will be 10% over its useful life of 10 years, but the company can sell the machine at the end of contract for $250,000 after incurring an additional cost of $24,000.

In consideration all the above factors, the company will have loss on sale of machinery of $88,000.

3.2 CALCULATION RETURN

OF

NET PRESENT VALUE

AND INTERNAL

RATE

OF

As a result of the Project analysis the NPV is positive and equates to $529,793. Positive NPV suggests that the project will be financially viable for Runwell Corporation. The usefulness of the NPV will depend on the accuracy of the expected income of the project and the discounted rate. If the discounted rate is set too low or expected income is too optimistic, then the NPV may reflect an overestimation of the project's potential (Ross 553). To calculate NPV for the new project WACC (14%) has been used. The WACC is a suitable discount rate for projects that are expected to be of average risk for the firm. The company’s overall WACC is not suitable for projects with risks that differ significantly from the average. Atypical projects require a relevant risk-adjusted weighted average cost of capital. In a situation with unexpected growth, a car manufacturing technology

discount rate should be increased. The NPV is inversely proportional to risk-adjusted discount rate as an increase in adjusted rate will decrease NPV, signifying that the new project is less acceptable and perceived as riskier one.

The following graph illustrates change of NPV with change of Discount Rate.

The graph is also showing that the Internal Rate of Return is 22.1%. IRR is the discounted rate at which the NPV of all the cash flows from the project equal zero. As a result if the Discounted Rate is below 18% Runwell should accept the new project. In the scenario if Runwell decided to agree to the sale of the contract it would be a poor decision as it will be less profitable and also time consuming to develop a new project.

3.3 DISCOUNTED

PAYBACK PERIOD

The Runwell Corporation discounted payback period is 5 years and it is one year less than the discounted payback period for the new project. It is a huge disadvantage to make the decision purely based on the discounted payback period as it ignores future cash flow and it biased against longterm and new projects (Ross 211).

3.4 OPTION

TO EXTEND THE

PROJECT

To increase the New Project period from eight to ten years has been analysed. The following assumptions have been observed: -

As it is a Business to Business contract it can be agreed by both sides to increase the period from eight to ten years with no extra cost

-

The final two years of sales revenue will decrease by 20% due to aged machinery

-

Fixed and Variable (45% from sales) costs stay the same

-

Machinery will depreciate and cannot be sold for $100,000 at the end of useful life. The additional cost of $50,000 will be incurred.

As a result the NPV for the new project spanning 10 years will be $820,498, which is higher than the 8 year project and also to be considered is the Internal Rate of Return of 21% (22% for 8 years project). The following table reveals the cash flow analysis for the project spanning ten years.

4 SUMMARY OF PROJECT ANALYSIS The following table summarises the recommendations from a cash flow analysis of a new line vehicle parts project. All recommendations are based on existing data provided by project team. Project Evaluation Criteria

Value

Net Present Value

NPV(8) = $529,793

Internal Rate of Return

IRR(8) = 22%

Discounted payback Period

6 years

Increase of Project contract to ten years

NPV (10) = $725,639 IRR (10) = 21%

Comments Positive NPV is expected to increase value of Runwell Corporation. Project is profitable. Greater than WACC, assuming that New Production Line project are more riskier and take in consideration that WACC represent only average risk of return of all projects, increase of WACC to 16-18% will be still less than IRR. Project should be accepted. It is less than recommended, but discounted payback period biased against long term project. Increase of NPV by xxx and IRR by xxx making Project more profitable and attractive from shareholders perspective

5 CONCLUSION Runwell Corporation should accept the new project because performed cash flow analysis indicates that excising project proposal will be profitable with a positive NPV, IRR of 22% and a discounted payback period of 6 years. A further suggestion is to increase the project period to ten years whilst the new production line still in operation.

6 REFERENCES Alhabeeb, MJ, 2012, Mathematical Finance, John Wiley & Sons, Hoboken, New Jersey.

Ross, SA, 2014, Fundamentals of Corporate Finance, McGraw-Hill, Australia....