This assignment document will seek to advise Engineering Products plc (“EP”) management on the best course of action in terms of whether to accept or reject the proposal for the new computer numerically controlled (CNC) milling machine. As the newly appointed financial analyst of the Steel Tube division of the company, Roger Davis is required to re-examine the accountant's profit projection and come up with a recommendation for the proposal. This assignment document will address various issues including relevant information for decision-making, the best approach to assessing the economic worth of the proposal, the limited use of cash and the effect of deferring other projects or options, in addition the assessment of strategic factors and the issue of 30% corporate tax and a 25% writing down allowance.
1. How much of the information which was gathered by Davis is relevant to the decision?
What is relevant, is easily defined as what information will help the company make a valid decision in terms of the investment proposal. What is valid is determined partly by the objective or purpose of the decision to be made and partly by the manner of how the decision should be made in relation to the choice of methods to be used. Therefore, to respond completely to this question, further discussion will be expanded upon in the answer to the next question. At this point, the purpose of the decision is to choose which of the options will support the corporate objective of wealth maximization. From the financial point of view, the best decision either minimizes the cost of the project or maximizes the net benefits and the final effect in either case is to maximize wealth of owners (Brealey, Myers & Allen, 2008).
2. What was the best approach to assessing the economic worth of the proposal? Should discounted cash flow techniques be used in addition or as replacement to the payback and return in investment methods used by the company?
The appraisal methods can be broadly categorized into non-discount and discount methods. Under the non-discount method is the accounting rate of return (ARR) method (Atkinson, et al 2005). EP appears to consider this method by using Return on Assets (ROA) of 16% as its division's accounting rate of return. This rate considers the net income of the business and divides the same with the average of investment made for the project and disregards the time value of money. The other non-discounted method used is the payback method, which requires a certain number of years to recover the amount of investment, and is generally shorter than the expected life of the project. EP's managing director appears to support a three-year payback method for the Steel Tube division.
On the other hand, through the application of the discount methods, EP can opt to use the net present value (NPV) method and/or internal rate of return (IRR). Methods which both consider the time value of money and the cost of capital. As a result, there is a need to discuss the importance of “time value of money”.
What is the time value of money? The cash flows generated from the business could be either cash inflows or cash outflows. The cash inflows represent the expected benefit of a certain proposal or project; while the cash outflows refer to the costs and other cash outlays that are needed to run the project like the requirement for additional working capital. The concept of cash flows and discounting are very much related to the concept of “time value of money” which assumes that a £1 today has more value or is preferable than £1 in the future. To equalize therefore the values of cash at different periods, there is a need to calculate their present values by discounting (Brigham and Houston, 2002). Using the cost of capital as a discount rate, a positive Net Present Value (NPV) makes the proposal acceptable while a negative value does the opposite.
The discount rate uses the cost of capital, which is also used implicitly in the Internal Rate of Return (IRR). However, its use in IRR analysis in equivalent ways as that of the NPV analysis does have some differences (Brigham and Houston, 2002).
In comparison, using IRR may be appropriate when the NPV of a project proposal is set to zero. The discount factor under the net present value analysis would coincide with the reinvestment rate used under the IRR analysis. IRR uses a rate for measurement, while NPV uses a pound (or dollar) amount to identify whether a proposal is acceptable. Based on this difference of the two methods, the use of cost of capital in IRR would appear easier to use since the acceptability of projects are normally expressed in rates of return. However, conflicts between the two methods may still exist. As an example, one conflict may arise when deciding upon mutually exclusive projects, where a decision must be made on one of the projects, but cannot reject or accept both. Thus, in the case where a conflict arises between the use of the two analysis methods, Brigham and Houston (2002) suggested the preferential use of cost of capital in NPV for accuracy reasons. As a result, among the four methods, NPV sounds the most superior.
2.1 Computing the values for the investment proposal with comments on the adjustments made and determining whether the investment proposal is financially acceptable.
The net present value of the investment proposal is negative £173.58. See Appendix A. The negative result makes the proposal unacceptable assuming a discount rate of 10% as an approximation of the company's cost of capital.
Note the net present value was computed by adjusting the prepared projection of the accountant including adjusting the depreciation using a shorter economic life of four years instead of 6 years on the ground the economic life of the machine should prevail. Other items are either added or subtracted as a result. The scrap value of £20,000 would form part of the cash inflow at the end of the project as found in Appendix A. Note also that the decreased life to four years is more realistic since the life of the product with due consideration of rapid developments in the market must be considered. After four years, it was assumed that it could no longer be used.
Other items that adjusted the net income or net loss include the following: Additional working capital at start of project, additional for sales promotions yearly, the consultant's fees and the reduction of competing product sales-net profit.
The effect of 30% corporate taxes was also reflected and after arriving at the net income after tax there were adjustments made including adding back depreciation and the fixed charges, which are include in the other production cost. In other words, the preparation of projected cash flows of the project considers only what are relevant in terms of their effect on cash flow as they were eventually discounted using the cost of capital at 10%.
The discount rate of 10% was basically acceptable as it assumes the risk free rate of 6% and there is a need to adjust the same to cover other risk as a result of making the decision to invest. The generated internal rate of return (IRR) on the other hand is negative 14%. This result reveals the power of IRR by displaying the rate as a final measure against cost of capital. Since the cost of capital is 10%, obviously using IRR would not make it possible to approve the project proposal.
The average accounting rate returns for the next four years of the project is negative 14%. Compared with the company's Steel Tube division's previous return on assets of 16%, the project would appear not acceptable as it fell well below the requirement. The payback period using non-discount value is more than 4 years since the accumulated amount of net income cannot reach the initial cash outlay at year 0.
The discounted payback period for the investment proposal is also more than 4 years. The annual net cash flows were discounted first using the cost of capital of 10%. Since the discounted payback is longer than the expected life of the project, there is basis on which to reject the project proposal. In addition, since the policy of the company requires a maximum payback of 3 years, under the policy the project cannot be accepted. Since this latter payback method is discounted, the time value of money is factored in just like the NPV and IRR, although the project is still not acceptable.
Since the case facts state that the managing director needs to be convinced that the spending £240,000 must make economic sense or Davis should forget the whole idea, Davis needs to include what is relevant. Therefore Davis needs to adjust the work of the accountant to reflect the economic values of the project proposal in terms of cash flow that would have to be discounted at a computed discount rate of 10%. The annual cash benefits suggested by the production manager are ignored as they appear speculative and the objective accounting was instead adjusted. The managing director merely requires project to pay for it self in 3 years without any requirements on cash flows. Hence, the payback period may refer to net income generated that would cover the investments or it could refer to the cash flows per year. As a result, all calculations of discounted payback may be prepared to support the 3 year criteria although may not fully support the NPV method for the purpose of making the correct decision.
3 How should the fact that cash was limited for this year and acceptance of this project could mean deferring the others, be taken into consideration?
This issue of alternative use of cash where its use will cause the consideration of one project to continue and defer the other deemed addressed by the concept cost of capital assumption since it is assumed that the opportunity cost is integrated in the use of the discount factor. This is the reason why using the 6% risk free rate could be used as a discount factor since investing money in a proposal would essentially restrict or reallocate the company's ability to earn the risk free rate. However since the 10% cost of capital was assumed to compensate for additional risk, this means that should the company forego this proposal, the alternative was to use the money for the deferred. Therefore, there is no more need to adjust further the cost of capital used since the essence of what are being discounted, as relevant cash flows should include the incremental cash outflows and inflows (Meigs, Meigs, & Meigs, 1995).
Davis must be correct in deciding to use 10% as the required rate of return, made up of 6% currently obtainable from risk-free government securities plus a small element to compensate for risk.
4 How should the strategic factors be assessed?
The strategic factors refer to the attainment of the long-term strategic objectives of the company, where management essentially accepts the short-term results in order to obtain its long-term strategic objectives. As applied in the case of EP, this project appears to have life of only four years and the projected cash flows for the next four years are assumed to be realized. Upon the completion of this project, it appears to indicate no evidence that this project will support EP's long-term strategic objectives. In the absence of such evidence, it could be assumed that anything providing short to medium term profits for the company can be presumed to support or sustain its long-term health.
The strategic factors should be assessed by looking at the effect of the current decision in relation to the long-term strategic objective of the organization. It can be assumed that a business has both short-term and long-term objectives and both are important for the life of the business organization. As a result, meeting the short-term goals and targets is a prerequisite for meeting its long-term strategic objectives.
5 How should the company take into consideration the issue of 30% corporate tax and the possibility of claiming 25% writing down allowance on the reducing balance?
Since the case facts outline that the existing machine has a nil value for tax purposes and is payable in the same year as the cash flow to which it relates, the same was considered not relevant for tax purposes in computing the corporate tax. In relation to the writing down allowance that may be claimed, a computation was made as per Appendix B. Its effect however is similar to that of depreciation since it will reduce the liability for income taxes. The same therefore was added back to reflect the effect in the cash flow. Since computed writing-down allowance was lower than when straight-line depreciation method is applied for four years, the resulting net income and net cash inflow is higher. This resulted to better ROA, IRR, NPV and better payback period. See Appendices A and B. Although even after recalculation, the project was still not acceptable using all the investment appraisal methods.
This assignment document has found the project to be unacceptable using the NPV, IRR, ROA and Payback methodologies. At the lower possible discount rate possible of 6% representing the risk-free rate, the NPV already generated a negative figure indicating that proposed project is not acceptable and would not result in creating greater wealth for the stakeholders. The resultant failure of the project using the NPV method, as the most scientific of all the methods becomes clearer if cost capital or discount rate is increased to 10%. IRR and ROA were even negative and the payback period exceeded the expected life of four years for the new machine. It is therefore by conclusion of this assignment research that the proposal for the new CNC milling machine is rejected by EP's management.
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