Capital budgeting analysis for Glow PLC's new security light machinery

Glow PLC

Identify the relevant cash flows to evaluate production of the new security light

In order to assess capital expenditure alternatives, it is imperative for the firm to determine the relevant cash flows. These include the incremental cash outflow, also perceived as the investment, and ensuing accruals (Bierman Jr. and Smidt, 2012). It is imperative to note that the incremental cash flows signify the extra cash flows, which might be inflows or outflows, anticipated to come about from the projected capital expenditure. The cash flows of this particular projected have the normal pattern, which encompasses three elements, and these are the initial investment, the operating cash inflows and the terminal cash flow (Bierman Jr. and Smidt, 2012).

Initial Investment

The term 'initial investment' encompasses the relevant cash outflows, considered when assessing a prospective capital expenditure, which in this case is new machinery. In particular, the initial investment takes place at time zero or year zero, which is the time at which the prospective capital expenditure is made (Bierman Jr. and Smidt, 2012). The initial investment is calculated by deducting all cash inflows taking place at year zero from all the cash outflows taking place in the same year. The cash flows that ought to be taken into consideration when ascertaining the initial investment linked with the capital expenditure include the installed cost of the new asset, the proceeds from the sale of an old asset and the change in net working capital (Horngren, Datar, and Rajan, M, 2012). In this case, there are no costs of installation and the company at the end of the fourth year will not be replacing the existing asset. As a result, the initial investment is equal to the purchase price of the new machinery adjusted for any alterations in net working capital (Bierman Jr. and Smidt, 2012).

The purchase price of the new machinery = $1,500,000

+ Consultation Fees = $250,000

+ Net Working Capital = $150,000

Initial Investment = $1,900,000

2. Operating Cash Inflows

The benefits projected from the capital expenditure, that is the new machinery, are projected in its operating cash inflows, which are incremental after-tax cash inflows. Benefits projected to come about from recommended capital expenditures are measured on an after-tax basis (Holmen, 2009). This is because Glow Plc will not have the usage of any benefits up until the point it has paid the corporation tax. As pointed out, Glow plc pays corporation tax on profits in the year following in which liabilities arise, at an annual rate of 12.50%. The following table indicates the calculation of operating cash inflows for Glow Plc's proposed new machinery (Bierman Jr. and Smidt, 2012).

Operating Cash Inflows for Glow Plc's Proposed New Machinery

Year 1

Year 2

Year 3

Year 4

Sales Units

14,000

16,000

16,000

14,000

Selling Price

Revenue

1540000

1920000

1920000

1400000

Expenses excluding depreciation

Material Costs

420000

480000

512000

476000

Direct Labor

210000

240000

240000

238000

Variable Overheads

70000

80000

96000

98000

Interest Bank Loan

120,000

120,000

120,000

120,000

Administration

100,000

100,000

100,000

100,000

Fixed Costs

80,000

80,000

80,000

80,000

Total

1

1100000

1148000

1112000

Profits before depreciation and taxes

540000

820000

772000

288000

Depreciation

250,000

250,000

250,000

250,000

Net profits before taxes

290,000

570,000

522,000

38,000

Taxes (rate = 12.50%)

36250

71250

65250

Net profits after taxes

253,750

498,750

456,750

33,250

Depreciation

250,000

250,000

250,000

250,000

Operating Cash Inflows

503,750

748,750

706,750

283,250

Calculate the Internal Rate of Return of the new product

Internal Rate of Return (IRR) is the rate of interest at which the net present value of the positive cash flows and the negative cash flows from a particular project or investment amount to zero. This interest rate is employed to assess the viability and desirability of an investment or a project (Atrill and McLaney, 2013). The IRR is calculated using the following formula:

IRR = Lower rate + NPV at lower rate / (NPV at lower rate -- NPV at higher rate) x (higher rate -- lower rate) (Horngren, Datar, and Rajan, M, 2012).

Assuming a discounting rate of 8%

PV Factors:

Year 1 = 1 + (1 + 8%) ^ 1 ? 0.925926

Year 2 = 1 + (1 + 8%) ^ 2 ? 0.857339

Year 3 = 1 + (1 + 8%) ^ 3 ? 0.793832

Year 4 = 1 + (1 + 8%) ^ 4 ? 0.73503

Present Value of Cash Flows:

Year 1 = 503,750 x 0.8850 = 466435.19

Year 2 = 748,750 x 0.7831 = 641932.44

Year 3 = 706,750 x 0.6931 = 561040.94

Year 4 = 283,250 x 0.6133 = 208197.21

Total Present Value of Cash Inflows: 466435.19 + 641932.44 + 561040.94 + 208197.21 = 1877605.77

Net Present Value (NPV) = Total Present Value of Cash Inflows - Initial Investment

= 1,877,605.77-1,900,000

= -22,394.23

Assuming a discounting rate of 7%

PV Factors:

Year 1 = 1 + (1 + 7%) ^ 1 ? 0.934579

Year 2 = 1 + (1 + 7%) ^ 2 ? 0.873439

Year 3 = 1 + (1 + 7%) ^ 3 ? 0.816298

Year 4 = 1 + (1 + 7%) ^ 4 ? 0.762895

Present Value of Cash Flows:

Year 1 = 503,750 x 0.8850 = 470794.4

Year 2 = 748,750 x 0.7831 = 653987.2

Year 3 = 706,750 x 0.6931 = 576918.5

Year 4 = 283,250 x 0.6133 = 216090.1

Total Present Value of Cash Inflows: 470794.4 + 653987.2 + 576918.5 + 216090.1 = 1917790

Net Present Value (NPV) = Total Present Value of Cash Inflows - Initial Investment

= 1,917,790-1,900,000

= 17,790

Therefore, at some point between 8% and 7% the evaluation of the project changes from being rejected (when NPV is negative) to being accepted (when NPV is positive). Therefore, we calculate the point at which NPV changes from being negative to being positive by examining the internal rate of return (IRR) in the following equation, (which makes the NPV=0) (Bierman Jr. and Smidt, 2012).

IRR = Lower rate + NPV at lower rate / (NPV at lower rate -- NPV at higher rate) x (higher rate -- lower rate)

IRR = 7% + 17,790 / (17,790 -- 22,394.23) x (8% - 7%)

= 7.44%

Therefore, the IRR is 7.44%

Write a brief report to senior management recommending acceptance or rejection of the project, outlining your reasons for the recommendation

After assessing the capital expenditure (that is the new machinery), by taking into consideration the cash inflows, cash outflows and cost of capital, it is my recommendation to senior management that the project should be rejected. The primary reason is that the project has a negative Net Present Value (-204,268.46). A negative NPV implies that the prospective project is projected expected to lose money and therefore ought to be avoided (Hagemann, 1990). An additional important reason is that the cost of capital, 13%, is greater than the internal rate of return, 7.44%. Therefore, I recommend the rejection of the project because the cost of capital is greater than the internal rate of return. This is because in its lifetime or economic period, the prospective project will not create value for Glow Plc. Therefore, in general, it is recommended that the senior management of Glow Plc reject the prospective project of new project (Hagemann, 1990; Horngren, Datar, and Rajan, M, 2012).

Acting as consultant to Glow plc write a report on the advisability of accepting the contract and any additional factors, which you feel, Glow plc should consider

Bank exchange rates:

Spot Rate = $1.095 / $1.120 = 0.9777

1 Month Forward = $1.105 / $1.131 = 0.9770

3 Months Forward = $1.128 / $1.152 = 0.9792

6 Months Forward = $1.158 / $1.182 = 0.9797

Contract signed for $3.4m will be paid in three months' time.

Using the spot rate, it implies that the signed contract in Euros will be 3,400,000 * 0.977 = 3,321,800 Euros.

In three months' time, the rate will be 3,400,000 * 0.9792 =3,329,280 Euros.

Report for Glow Plc

As already informed, the company is interested in signing a contract with a U.S. firm for $3.4m for one of its other products. This agreed amount will be paid in three months' time. In addition, as assessed, the company determined that the cost incurred will be 3.05 euros. The main advice given to the company is to sign a forward contract with the company. A forward contract can be defined as a private agreement struck between two parties, which gives the buyer an obligation to buy an asset while on the other hand the seller an obligation to sell an asset at a set price at a future point in time (Guidotti, 2016). Therefore, this implies that the company will be paid with the present exchange rates in the three months. According to calculations made, if the company agrees to be paid using the spot rate, then it will receive a total of 3,321,800 Euros. However, in three months' time, the company will receive a total of 3,329,280 Euros. Therefore, this means that the company stands to obtain greater profit in the latter arrangement, than in the former. Therefore, making a future agreement with the company will be more beneficial for Glow Plc. However, there are a number of other elements that ought to be taken into consideration as well (Guidotti, 2016). One of them is whether these predetermined exchange rates will have an impact on the costs incurred by increasing them or decreasing them. More specifically, the factors that affect the creation of the product should be taken into consideration. Currency futures are also impacted by several factors, most significant being the policies of the Federal Reserve and the U.S. Treasury as regards money supply. Government policies concerning taxation as well as other decisions to decrease the level of inflation will also have an influence on currency futures (Guidotti, 2016). For instance, the contemporary performance of the dollar set against the opposite currency in the contract plays a significant role in determining the price at which a futures contract can be struck (Guidotti, 2016).