Capital Budgeting Analysis Of Emu Electronics
Analysis
Describe the Report for Emu Electronics as an Electronics Manufacturer.
Introduction
The case is about Emu Electronics which is situated in Box Hill, Victoria. The company was founded more than 50 years ago and it used to repair radio and other household appliances. The company has grown over the years and is a specialty dealer in electronics item. At present the major revenue source of the company is smart phone. The company has designed a new smart phone with all existing features and built in Wifi tethering facility. For the development of this phone the company has invested 750000 in development of the prototype of the new smart phone. Emu has also spent 200000 for marketing study so that they are able to forecast the demand of the new smart phone being launched. The company has also calculated the variable cost and fixed cost that will be incurred in running the operation of the manufacturing facility which will produce the new smart phones. Shelly Chan is the current managing director of the company and she has inherited the company from her father. She wants to calculate the various parameters involved in capital budgeting of the company so that she can take decision about the project and how to reduce the costs to increase efficiency and profit of the organization.
The Emu electronics wants to calculate the various parameters involved in capital budgeting of the company. Capital budgeting is a technique used by the companies to estimate whether the investments made in the project will be able to provide returns to the investors. It takes into account all the cash flow from the various revenue sources in the future and all possible expenditure to estimate the profit from the investment. The expenditure includes investment in property, equipment, market study and research and development. These are also called capital expenditure.
The cash flow from the various revenue sources in the future are discounted using the discount rate to calculate the present value of the earnings in the future. The discount rate of the project depends upon the financial risk involved in the project. The company tries to minimize the financial risk involved in the project by using different ratios of debt and equity while financing the project. The ratio of debt and equity is maintained such that the risk is minimized and overall profit to the company increases.
The main objective of any project under taken by a company is to maximize profit for the shareholders. The profit can be maximized by reducing cost or increasing revenue from the project.
Payback Period
In this case, the source of revenue is by sales of smart phones and the expenses each year is due to the variable cost involved in manufacturing smart phone and the initial investment is for the purchase of the equipment required for manufacturing the smart phones.
Thus in the year 0, the company makes the investment of 34.5 million for the equipment cost. The Research and development cost of 750000 and the marketing cost of 200000 is sunk cost and hence not a part of the capital expenditure.
Depreciation is calculated using straight line method for 7 years and the salvage value is 0. However at the end of the 5 years, an amount of 5500000 can be received for the equipment.
Thus depreciation = (34.5 – 0)/ 7 = 4.928 million
In the first year,
The number of mobile units sold = 64000
Price of the smart phone = 485
Thus revenue earned = Units sold* Unit selling price = 106000* 485 = 31040000
Variable cost per unit = 205
Thus total variable cost = Units sold* Unit variable price = 205* 64000 = 13120000
Fixed cost each year for operation of plant = 5100000
Thus net profit = Revenue – variable cost – fixed cost = 31040000 – 13120000 – 5100000 = 12820000
EBIT = Net profit – Depreciation = 12820000 – 4928571 = 7891429
Tax = 30% of EBIT = 30% * 7891429 = 2367429
Profit before tax = 7891429 – 2367429 = 5524000
Working capital = 20% of revenue = 20% * 31040000 = 6208000
Change in working capital = working capital (year 1) – working capital (year 0) = 6208000 – 0 = 6208000
Capital expenditure in year 1 = 0
Free cash flow = Profit before tax + Depreciation – Change in working capital – capital expenditure
Thus in year 1, Free cash flow = 5524000 + 4928571 – 6208000 – 0 = 4244571
Discount rate = 12%
Present value = Free cash flow/ (1 + r)^n = 4244571/ (1 + 0.12)^1 = 3789796
Similarly, the values for other years are calculated.
The table of all the values for the next 5 years is given below.
The payback period is defined as the amount of time required by the company to recover the investment it has made in the project using the revenue generated from the project. Payback period helps manager to decide whether or not they want to accept the project. A project is accepted by the management if the payback period calculated is less than the targeted payback period i.e. the amount of time required by the company to recover the initial investment is less than the expected amount of time by the management. (Investopedia, Payback Period, 2011)
Profitability Index
In this case, the initial investment is 34.5 million and the revenue is generated from sales of the smart phones. Payback period = Investment/ Sum of cash flows till break even = 34500000 / (4244571 + 14610571 + 16803571)
= 2.90 years
A drawback of using Payback period for determining acceptability or rejection of a project is that Payback period does not take into account time value of money and can lead to inaccurate decisions.
Profitability index is defined as the ratio of the present value of all the future cash flow and the investment made initially in the project. It is also used to help managers decide whether or not they want to accept the project. A project is accepted by the management if the Profitability index calculated is more than 1 and is rejected if the Profitability index calculated is less than 1.
In this case, the Profitability index = Sum of the present value of all the free cash flows / Initial Investment = 47572084/ 34500000 = 1.40
The Profitability index calculated is more than 1. Hence the project can be accepted.
Internal rate of return is defined as the discount rate at which the net present value of all the future cash flow for a project becomes zero. It is also used to help managers decide whether or not they want to accept the project. A project is accepted by the management if the Internal rate of return calculated is more than targeted rate of return and is rejected if the Internal rate of return calculated is less than targeted rate of return. (Investopedia, 2013)
In this case, Internal rate of return r then
NPV = = 0
Thus calculating we get r = 24.6%
Net Present Value (NPV) is defined as the net present value of all the future cash flow for a project obtained by discounting all the future cash flow at the discount rate. It is also used to help managers decide whether or not they want to accept the project. A project is accepted by the management if the Net Present Value calculated is more than 0 and is rejected if the Net Present Value calculated is less than 0. (Investopedia, 2011)
In this case,
NPV = , where F0 is the initial investment
= 14072083.64
The advantage of using the Net Present Value is that NPV takes in to account all the future cash flows and time value of money. Also it helps the management understand the amount of money the project is going to generate for them.
Internal Rate of Return
However the disadvantage of using NPV is that it does not takes into account the initial investment required for the project. It assumes that the company will be able to get funds for starting the project which is not always feasible. Also NPV is affected highly by the future cash flows, tax rate, etc. which makes it fluctuate too much due to small changes in the variables.
To test the sensitivity of the NPV to the changes in selling price, we had two approaches: optimistic where we increased the selling price by 5% and pessimistic where we decreased the selling price by 5%.
When the selling price is increased by 5%, the new selling price = 485 * 1.05 = 509.25
Thus calculating the NPV, we get, NPV (optimistic) = 18757736
When the selling price is decreased by 5%, the new selling price = 485* 0.95 = 460.75
Thus calculating the NPV, we get, NPV (pessimistic) = 9386431
(Investopedia, 2011)
To test the sensitivity of the NPV to the changes in quantity, we had two approaches: optimistic where we increased the quantity by 5% and pessimistic where we decreased the quantity by 5%.
When the quantity is increased by 5%, the quantity for 1st year = 64000* 1.05 = 67200
Similarly for other years quantity is calculated.
Thus calculating the NPV, we get, NPV (optimistic) = 167217102
When the quantity is decreased by 5%, the new quantity for 1st year = 64000* 0.95 = 60800
Thus calculating the NPV, we get, NPV (pessimistic) = 11422565
Thus it can be seen that NPV is more sensitive to the changes in the selling price and less sensitive to the quantity.
Yes, Emu Electronics should go ahead with the production of the smart phones. It can be seen from the calculation that the NPV is positive for the project and IRR of the project is more than the rate of return of the company. The only constraint the company has is it requires 34.5 million to start the project. If it is able to arrange the investment using equity or debt without any change in the rate of return then it should go ahead with the production of the smart phones.
(Goedhart, 2015)
If the sale of new smart phone reduces the sale of other phones, it is loss in revenue for the company as the new product is cannibalizing its own products. Thus to account for this change in revenue, the company must reduce the revenues earned by the sales of new product by the amount of money lost due to loss in sales of old phones. Thus the net present value, internal rate of return and payback period will change and there is a possibility that the project might become unfeasible if the loss in sales is too high. Thus it can have serious impact on the final decision of the project
Net Present Value
Introduction
Hubbard Limited Company was founded by Bob and is family owned business. Its sell computer products and other accessories. The company wants to calculate WACC to understand the cost associated with the business. The company has chosen Harvey Norman as a representative company which is a listed company so that it can determine the cost of debt and equity of the company.
Long term debt excluding the current liabilities = 290000000
Total assets owned by the company = 4430000000, total liabilities of the company = 1740000000
We know, Total Assets = Total liabilities + Equity
Thus the equity of the company = Total Assets – Total liabilities = 4430000000 – 1740000000 = 2690000000
The market value of the equity = 5.77 billion
No. of outstanding shares = 1113 million
Annual dividend paid most recently = 0.17 per share
Beta value = 0.75
Yield on government debt = 2.45% for a 3 month bond
Market risk premium for Harvey Norman = 5%
We know using the Capital Asset Pricing model,
Cost of Equity = Rf + (Rm – Rf)* Beta
= 2.45% + (5 * 0.75) = 6.20%
The dividend discount model is not applicable in this case as the dividend paid by the company is not set.
Interest expense = 32080000
The book value of the long term debt = 290000000
Cost of debt = Interest expense/ book value of the long term debt = 32080000/ 290000000
= 11.06%
As the data regarding the market value of debt is unavailable, we assume the market value of debt is same as the book value of debt
(Mitra, 2011)
Total value of the company = Book value of equity + Book value of long term debt
= 2690000000 + 290000000 = 2980000000
Thus Weighted average cost of capital = Equity book value/ Total book value * Cost of equity + Debt book value/ Total book value * Cost of debt * (1- rate of tax)
= 6.35 %
Again using the market values of debt and equity instead of book value, we get
WACC = 6.27%
The cost of capital calculated at market value is more relevant as it gives idea about the prices at which the company can sell.
(Patient Value, 2013)
Apart from the major financial differences, the portfolio of the HCL is different from the Harvey Norman. Harvey Norman has a larger variety of electronic goods in its product portfolio whereas HCL has only computer and its accessories. This again diversifies the risk of Harvey. The customers get wider range at Harvey Norman and it is easier for them to convert customers and build trust than HCL. Thus it is not correct to use Harvey Norman. (Winkle, 2011)
Conclusion
Thus the assignment helps in understand the various topics in capital budgeting. In the first part, the various parameters used by the management for deciding whether or not they want to accept the project. It was found that the NPV of the project is positive and IRR of the project is more than the rate of return of the company. Thus if the company is able to arrange the investment using equity or debt without any change in the rate of return then it should go ahead with the production of the smart phones. In the second part, the method to calculate WACC was explained and the issues in using another company as a representative company were discussed.
References
Investopedia, 2011, Payback Period, viewed September 26, 2016 <https://www.investopedia.com/terms/p/paybackperiod.asp>
Gallo, A., 2016, A Refresher on Internal Rate of Return, Harvard Business Review, viewed September 26, 2016 < https://www.thebalance.com/net-present-value-npv-as-a-capital-budgeting-method-392915>
Mitra, S., 2011. Revisiting WACC. Global Journals, viewed September 26, 2016 < https://globaljournals.org/GJMBR_Volume11/8.Revisiting-WACC.pdf>
Goedhart, M., 2015, A better way to understand internal rate of return, Mckinsey, viewed September 26, 2016 < https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/internal-rate-of-return-a-cautionary-tale>
Patient Value, 2013. WACC Is Flawed, Use Warren Buffett’s Approach Instead, viewed September 26, 2016 <https://seekingalpha.com/article/1641702-wacc-is-flawed-use-warren-buffetts-approach-instead>
Investopedia, 2011, Net Present Value – NPV, viewed September 26, 2016 < https://www.investopedia.com/terms/n/npv.asp>
Investopedia, 2013, Internal Rate of Return, viewed September 26, 2016 <https://www.investopedia.com/terms/i/irr.asp>
Winkle, L., 2011. Harvey Norman shares: Should you really buy them?. Financial Review. viewed September 26, 2016 <https://www.bofaml.com/content/dam/boamlimages/documents/articles/D3_014/bro-04-15-1256_f_singlepages.pdf>