Capital Budgeting and Financial Analysis

Blessing Oduguwa
London School of Business and finance

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Table of Contents
1.0 EXECUTIVE SUMMARY............................................................................................................... 2 2.0 INTRODUCTION ............................................................................................................................ 2 3.0 WORKING CAPITAL MANAGEMENT........................................................................................ 2 3.1 WORKING CAPITAL POLICIES ............................................................................................... 2 4.0 NET CASH FLOW ........................................................................................................................... 4 5.0 NET PROFIT VALUE, WACC AND IRR ...................................................................................... 4 According to DeGenaro, 2001 ................................................................................................................ 4 6.0 Risk- Sensitivity Analysis ................................................................................................................. 4 Reference List ......................................................................................................................................... 7

1.0 EXECUTIVE SUMMARY 2.0 INTRODUCTION

3.0 WORKING CAPITAL MANAGEMENT Working capital can be referred to the balance that is derived between current liabilities and current asset. This may vary depending on the type of firm. A balance sheet consists of different financial classifications, which are: fixed asset, current liabilities, current asset, long-term loans, and shareholders equity. Current asset and current liabilities are the key modules of working capital. However, working capital can also be the day to day activities of a business which is made up of its current asset and current liabilities. The current assets consist of inventories, cash, trade receivables and short term investment. While Current liabilities consist of trade payables and bank overdrafts. Working capital can be either positive (current asset are more than current liabilities or negative (current asset are lesser to current liabilities). In an organisation it is difficult to maintain and achieve the best possible level of working capital. For instance, there are two effects of which a large volume of inventories can be achieved. Firstly money has been used to generate inventories, but returns are not generated. Secondly, customers are always happy because stocks are always available. Companies should be able to keep working capital (trade receivables, inventories and cash) at a level to ensure customer goodwill is kept at minimum cost. According to Abuzayed (2012), the current financial crisis and the recession that took speed through 2008 have brought more focus to the investment that firms make in shortterm asset, and the resources used with maturities of under one year which represent the main share of items on a firms balance sheet. In conducting a companys daily operation, balancing liquidity and profitability can be challenging decisions. Abuzayed (2012), also states that liquidity is a precondition to ensure that firms are able to meet their short-term obligations and their continued flow can be guaranteed from a profitable venture. 3.1 WORKING CAPITAL POLICIES Companies have different polices depending on the management of working capital. Some financial management companies implement conservative polices, implement aggressive approach and some use middle of the road approach.

Aggressive approach: according to Weinraub and Visscher (1998), aggressive approach manages current asset by holding small amount of current asset with the hope of producing high returns for the firm. An example of this can be having small amount of cash in near cash asset or non-interest-bearing account, a company invest in long term investment car with the hope to make higher returns. Another example can be of a company investing on a productive asset such as equipment and plant, aiming for a more profit over a long period. Aggressive policy can be associated with high risk, if a company has a small amount of cash or near cash asset, there is a possibility that the company will not have enough cash in ground to for short term requirement at the due time. Also in aggressive policy if there is lack of inventory on ground, there is a risk of losing sales or running out of stock. A retail industry can be a good example for this Pass and Pike (1993). Conservative policy approach: the management of current asset in conservative approach involves keeping of extra inventory levels and extra cash. Thus cash will be available to meet unpredicted liquidity needs low stock will be avoided. Therefore, high returns are regularly sacrificed. The conservative policy for current liabilities involves investing on both the long term needs and short term needs by protecting current liabilities to its minimum. Therefore funds are available for financing for a longer period at a fixed rate, in most cases at a high cost. Also there are periods where company pay interest on funds which are not required at specific period. Middle of the road approach (policy): In a nut shell matching principle indicates those permanent assets funded through long term basis are funded through short term resources. Part of current assets like inventories and accounts receivables is a requirement for company needs. Working capital policy should consider itself stable for current liabilities and current asset, in financing, tenacity are referred to long term liabilities and long term asset. Finally company using any of the working capital policy ( conservative working capital policy, aggressive working capital policy and middle of the road working capital policy must understand the policy choices, its risk and implication that are involved, and be prepared to adjust the changes in the companys working capital policy in its financial environment.

4.0 NET CASH FLOW 5.0 NET PROFIT VALUE, WACC AND IRR
NET PRESENT VALUE (NPV): According to DeGenaro, (2001) the NPV method measures the profitabilty of a project by discounting future cash flows at a desired rate to determine their present worth and then deducting the investment from this present value to get the net present value. A discount rate is determined to start an NPV calcultaions. The rate in the NPV can be premuim plus the cost of capital. In the NPV method, achieving the discount rate is challenging part. If a project NPV is positive, it is measured good but if the project NPV is negavtive, it is measured bad. For example in the case study provided in the assignment hand book, NPV of the project was asked to be determined at the average cost of 10% which gave an answer of 178.87. The project (FabX7) has a five year life value. The initial investment of net property, plant and equipment is equal to 10%. The discount rate in NPV is hard to justify, however it has its advantages which is easy to figure, when the discount rate is agreed. WACC: is a useful tool in capital budgeting in decision making for discount rate. It is also used to find the NPV of a project that would not be at any risk to the firm. For capital investment it acts as handle rate that gives a particular return on investment. The balance sheet data and the variables are used to calculate WAAC. However when using WACC the company should know that industry costs may improve than individual companys cost in the process of using investment appraisal. The WACC of 10% is the average cost of capital, this will be appropriate if the risk of FabX7 and Maxi-cooper is similar.

6.0 Risk- Sensitivity Analysis

Sensitivity analysis deals with safety margin that exists earlier than the project turns into nonviable. Sensitivity analysis allows the manager to feel the risk of the project before getting involved (Atrill & Mclaney, 1994). Assumptions on preference, competitor, economy and customer taste are based on the estimated cash flows. However the first thing a manager should consider about the estimated cash flow is the sensitivity of the assumptions listed above. An example is if there is a sale of 4 million units as a substitute of 6 million at the beginning of the year, will the project be seen as profitable or if the tax rate is increased is the project still attractive. The sensitivity of cash flow can change if the cash flow is been reestimated for diverse scenarios. Sensitivity analysis can also mean scenario analysis; this method looks at the consequence that might happen in if there is a change in the analysis. The

changes effect that shows in assumption is illustrated by sensitivity analysis. Sensitivity analysis can be classified as real, because the focus is only on one change. During the lifetime of a project, different factors can change. For instance in FabX7 and Maxi-cooper, there are different assumption that are made due to uncertainty, this include arriving at a negative project for FabX7. In calculating this, assumption can be made on the economy, price and the firms competitors (Peterson, 2002). Managers in charge of the decision making in an organisation are aware of the uncertainty around the project which my produce a negative NPV. The uncertainty can be derived from the distribution of occurrence which is the chance of a negative value. In the graph below the probability of a negative NPV can be seen under the line of the Y axis. The graph shows that, at the discount rate of 30per NPV was -23.23, at 40percent NPV was -62.59 and at 50percent NPV was 89.65. But because the question says undefined values, decision makers should highlight existence of the negative value.

NPV versus WACC

200 150 100 50 0 0 -50 -100 0.1 0.2 0.3 0.4 0.5 NPV versus WACC

Years 0 1 2 3 4 5

Net CF -309.09 61.21 88.95 125.76 126.5 288.26

Discount Rate

0.10

0.20

0.30

0.40

0.50

NPV

163.58

44.43

-23.23

-62.59

-85.69

IRR = 20% + [44.43/ (44.43+23.23) x 10%] = 26.57% Risk is a very important aspect that should be involved in any investment opportunity. A manger decides which project is worth investing in and considers which Net profit Value (NPV) to choose. Later, a manager should carry out a risk analysis, scenario analysis and sensitivity analysis. A manager feels better about the risk in a project because sensitivity analysis displays NPV in different assumptions (Ross et al, 2005). The capital budgeting for Maxi-cooper and FabX7 is to determine the net cash flows and NPV of a proposed FabX7 series car which expected to generate revenue equal to 3% of the total revenue for Maxicooper Co fiscal year ended (Ghimire 2012). As a manager the first step is to analysis the future states of the operating cash flow for the two companies. The first calculation gave an NPV of 163.58 and IRR of 26.57%. At this stage NPV is in a major risk. PART B The part B of this assignment is based on Ratios, has instructed in the assignment to download balance sheet and income statement of two companies for the period of four years. For this assignment the company chosen are food industry companies which are Tyson foods and Starbucks. The researchers goes ahead to find out its share capital for each financial year from yahoo and the industry average from Reuters. Tyson foods Inc. was established in Springdale, Arkansas, it is now among the largest marketers and processor of pork, chicken and beef. Tyson have a number of competitors like Pilgrim Pride, Hormel and Smithfield. It has more than 107,000 employees in 300 offices worldwide (Tyson.com). There is high competition among its rival. Company in this industry compete for a market share. For a company to compete in this kind of industry, they have large image and great brand appearance. Income statement: Ratio Analysis: Tyson financial is required to assess its financial performance. And predict its future performance. To realise the financial performance, the cash statement, balance sheet and financial ratio was download from Marketwatch.com the cash flow and balance was compare to the one of Starbuck corp. Two qualities have been choosing to analysis, the

valuation ratio and profitability ratio. The Profitability compares Tyson and Starbucks and their ability to make profit. By observing its operating margin, net profit margin and return on equity. Operating Margin: is the calculation of sales that make up of taxes, the earnings before interest, depreciation and operating income. The high in percentage means that sales generate more income for the company. Net profit margin: net profit margin can also be referred to as the return on sales this can be calculated as net income over sales. This means the profit generated from sales every year. Return on equity: return on equity can also mean return on asset, in the hope that owner profitability is measured. Every year competitors have higher earnings than Tyson. Tyson generate low ratio in the years

Reference List

Abuzayed, B., 2012. Working capital management and firms' performance in emerging markets: a case of Jordan. International journal of management Finance , 8(2).

Atrill, P. & McLaney, E., 1994. Management Accounting- An Active Learning Approach. Oxford: Blackwell Business Publishers. Baumol, W., 1952. The Transactions Demand for Cash: an inventory Theoretic Approach. Quarter Journal of Economics, 66(4), pp. 545-556. Christopher Pass, R. P., 1993. Management of Working Capital: A Neglected Subject. Management Decision, 25(1). D.J.smith, 1994. Incorporating Risk into Capital Budgeting Decisions Using Simulation. Management Decision, Volume 32, pp. 22-26. DeGenaro, M. H. A. G. J., 2001. What every manager should know about capital budgeting. Advanced Management Journal. Ghimire, B., 2012. Capital Budgeting and Financial Analysis. In: Accounting and Corporate Finace. Manchester: London School of Business and Finance, pp. 16-17. H. Almeida, M. C. a. M. S. W., 2004. The cash flow sensitivity of cash. Journal of Finance, Volume 4. Peterson, P. P. F. F. J., 2002. Capital Budgeting: theory and practice. s.l.:John wiley and sons. Reuters, 2012. Markets. [Online] Available at: http://www.reuters.com/finance/stocks/financialHighlights?symbol=TSN.N [Accessed 12 April 2012]. Ross, S. W. R. a. J. J., 2005. Corporate Finance, New York: The McGraw-Hill Companies.

Appendices Appendix 1 Second year 1833 x 1.2 = 2200 Third year 2200x 1.15= 2530 Fourth year 2530 x 1.10 = 2782 Fifth year 2782 x 1.10 CALCULATIONS FOR THE WORKING REQUIREMENT 0 1 2 3 4 1833 81.39 1 -16.29 2200 97.68 2 -14.65 2530 112.33 3 -11.19 2782 123.52 4 -12.39

Year Sales required (4.44% of Sales) Timing in year Increment

5 3061 135.91 5 135.91

0 -81.39

Appendix 2 CALCULATION OF INITIAL INVESTMENT 0 1 2 3 -227.7 -250.47 -262.99 265.62

Year Required 10% of property plant, and Equipment firming years Increment: 1st year 22.7x1.1 2nd year 250.47x1.05 3rd year 262.99x1.01 4th year 265.62x1.01 5th year 268.28x1.01

4 -268.28

5 -270.96

227.7

-22.77

-12.52

-2.63

-2.66

-2.68

Appendix Calculation of operating cost Sales-cost= profit Sales= 61, 101 Profit= 3961 Cost=Y If y= cost Sales y= profit 61,101-y=3961 61,101-3961=y Y=57,140

Percentage of cost of sales 57,140/61,101x100=93.52% Cost percentage=93.52%

Appendix CALCULATION OF TAX Income before tax =3,324 Income tax =846 Let y= tax rate y/100x3324= 846 3324y/100x846 3224y= 84600 Y=84600/3324=25.45% Appendix 3 3324y/100x846 3224y= 84600 Y=84600/3324=25.45%

CALCULATION OF NET CASH FLOWS YEAR 0 Intial investment -227.7 Sales Revenue Operating cost (93.52%) Operating profit -227.7 Tax @ 25.5% Working capital -81.39 Tax Saving Net cashflow 309.09

1 -22.77 1833 -1714 96.23 -24.54 -16.29 5.81 61.21

2 -12.52 2200 -2057 130.48 -33.27 -14.65 6.39 88.95

3 -2.63 2530 -2366 161.4 -41.16 -11.19 6.71 125.76

4 -2.66 2782 -2602 177.34 -45.22 -12.39 6.77 126.5

5 -2.68 3061 -2863 195.32 -49.81 -135.91 6.84 288.26

Apendix 4 CALCULATION OF NET PROFIT VALUE YEAR 0 1 Intial investment 227.70 22.77 Sales Revenue 1,833.00 Operating cost (93.52%) 1,714.00 Operating profit 227.70 96.23 Tax @ 25.5% 24.54 Working capital 81.39 16.29 Tax Saving 5.81 Net cashflow 309.09 61.21 Discount Rate 10% 1.00 0.91 309.09 55.64

2 12.52 2,200.00 2,057.00 130.48 33.27 14.65 6.39 88.95 0.83 73.47

3 2.63

4 2.66

5 2.68

2,530.00 2,782.00 3,061.00 2,366.00 2,602.00 2,863.00 161.40 41.16 11.19 6.71 125.76 0.75 94.45 177.34 45.22 12.39 6.77 126.50 0.68 86.40 195.32 49.81 135.91 6.84 288.26 0.62 179.00

488.96 NPV 179.87

Apendix 5 CALCULATION IRR AT THE DISCOUNT RATE OF 28% YEAR 0 1 2 Intial investment 227.70 22.77 12.52 Sales Revenue 1,833.00 2,200.00 Operating cost (93.52%) 1,714.00 2,057.00 Operating profit 227.70 96.23 130.48 Tax @ 25.5% 24.54 33.27 Working capital 81.39 16.29 14.65 Tax Saving 5.81 6.39 Net cashflow 309.09 61.21 88.95 Discount Rate@28% 1.00 0.78 0.61 309.09 47.81 54.26 303.59 5.50

3 2.63

4 2.66

5 2.68

2,530.00 2,782.00 3,061.00 2,366.00 2,602.00 2,863.00 161.40 41.16 11.19 6.71 125.76 0.48 59.99 177.34 45.22 12.39 6.77 126.50 0.37 47.19 195.32 49.81 135.91 6.84 288.26 0.29 94.34

INCOME STATEMENT AND BALANCE SHEET OF TYSON FOODS