Analysis of Capital Budgeting Decision for Riverlea Limited Project

This report provides a comprehensive analysis of a capital budgeting decision made by Riverlea Limited regarding a potential project to supply confectionary to Wowcoles. The report utilizes Net Present Value (NPV) and other capital budgeting techniques like IRR and Profitability Index to assess the financial viability of the investment, considering incremental revenues, costs, and depreciation. Sensitivity analysis is conducted to account for uncertainty in revenue projections, providing best-case and worst-case scenarios. Additionally, the report examines the Efficient Market Hypothesis (EMH) by analyzing Riverlea's share price movements around the project announcement. The findings indicate a positive NPV, supporting the project's feasibility, and suggest the share price may not fully reflect the intrinsic value, recommending a buy strategy. The report concludes with recommendations based on the capital budgeting and EMH analyses.

Capital Budgeting
Decision
Riverlea Limited

Executive Summary
Riverlea Limited is looking at supplying confectionary to Wowcoles for which it will have to
expand its capacity by purchasing a new machine. An analysis was carried out for the
investment project with the help of capital budgeting techniques specially Net Present Value.
Also a sensitivity analysis with respect to the change in expected revenues for both
pessimistic and optimistic views was done.
The results showed a positive NPV for the base, best and worst scenarios. This means the
project is feasible for the company and the company should invest in the machine.
Also the semi weak strong EMH was tested for the share price of Riverlea with respect to the
change in stock price as a result of the announcement, it was seen that the semi strong form
did not exist as the stock prices did not fully reflected the increase in intrinsic value and also
the prices increased prior to the announcement.
Contents
Part 1.....................................................................................................................................................1
Introduction.......................................................................................................................................1
Findings.............................................................................................................................................2
Conclusion and Recommendations...................................................................................................3
Part 2.....................................................................................................................................................4
Introduction.......................................................................................................................................4
Findings.............................................................................................................................................4
Conclusion and Recommendation.....................................................................................................5
Bibliography...........................................................................................................................................5

Part 1
Introduction
For a business to undertake a new project, it is important to analyse the risks and returns
associated with that investment project. Capital budgeting is a tool that provides for such
analysis and helps in ascertaining the economic and financial profitability of any such
investments. There are a number of techniques which might be used in the capital budgeting
process to provide an analysis of the projects profitability. Some of these techniques include
Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index, Payback Period
(Fabozzi & Drake 2008). However, the most effective of the above is NPV as it gives
absolute measure of the profits from the investment.
In the current scenario, Riverlea Limited, a public listed company is in the process of
negotiation with Wowcoles, a supermarket chain to supply confectionary in a private label for
Wowcoles. The project is for a period of 10 years and in order to undertake the project, the
company will have to undertake a long term investment of purchasing a new machinery to
increase its production levels.
An analysis of the project was performed taking into account all the incremental revenues and
costs with the help of capital budgeting techniques. Also a sensitivity analysis was conducted
to see the effect of lower revenues on the NPV. The findings have been discussed below.
Findings
The NPV of the project was derived taking into account the incremental revenues, variables
costs, the decrease in current revenues, decrease in current operating costs, depreciation on
the new machinery, the initial investment required and the terminal value of cash flows. Also
the payback period, IRR and Profitability index were calculated to confirm the results.
The various assumptions taken for the analysis are:
 The decrease in current revenues is considered as an opportunity cost and is
considered a cash outflow
 The decrease in current variable costs is considered as a cash inflow

 The new machinery has been depreciated on a diminishing value method. The value
of machinery to be depreciated is the cost of machine plus its installation and shipping
charges.
 Tax rate has been assumed to be 30%
 There is an increase of working capital and subsequent increase in working capital
from 1 to 9 years. All the working capital is assumed to be recovered at the end of the
project i.e. the 10th year of the project.
 For discount rate, the cost of equity has been considered.
 Cost of equity has been calculated using the CAPM approach, where the risk free rate
is the average return on the 10 year Australian Government Bond, market return is the
average return of ASX200 from 1997 to 2016. Beta has been calculated using the
variance and covariance approach.
The NPV of the project is $14, 74,895.7. All calculations have been shown in excel.
Now, conducting a sensitivity analysis to compensate for the uncertainty of the expected cash
flows, the results are as flows:
Techniques Base case
Allow for a 40% probability
that incremental revenues
associated with the supply will
be 40% lower than expected
starting from year six.
Allow for a 10% probability that
incremental revenues associated
with the supply will be 20%
higher than expected starting from
year six.
NPV $14,74,896 $11,85,514 $15,11,068
Payback
period 4.6 4.6 4.6
IRR 21% 19% 21%
PI 1.8 1.7 1.9
Conclusion and Recommendations
The acceptance rule for NPV is that accept the project if the NPV is positive or else reject the
project. This is because NPV is the difference of the total present value of cash inflows and
the cash outflows. Here the NPV of the investment by Riverlea Limited is positive, hence
according to the NPV rule, the project should be accepted. This means the cash inflows
discounted at the company’s cost of equity is more than the cash outflows and hence the
investment in the new machinery to supply confectionary to Wowcoles proves beneficial for
the company as the cash inflows in the form of revenues is more than the cash outflows in the

form of initial investment and other operating costs. Also the payback period is within the
investment period, the IRR is more than the cost of capital and the PI is more than 1. All the
capital budgeting techniques give a positive result for the project.
Since the company is relying on a future outcome, hence the forecasted cash flows cannot be
assumed to be totally accurate, so to have an idea as to how the company’s cash flows will
look like under different scenarios, a sensitivity analysis was conducted taking into
consideration two scenarios of higher and lower expected revenues. Scenario 1 where there is
a 40% probability that the incremental revenues will be lower by 40% from year six onwards,
the NPV has fallen by almost 20%. And for scenario 2 where there is a 10% probability that
the incremental revenues will be higher by 20% from year six onwards, the NPV has
increased by almost 2.5%. Under both conditions, we have taken a pessimistic approach in a
way that the incremental revenues are falling by a higher percentage and the probability of
the fall is also much higher than the probability of an increase in the revenue. Still, we see
that the NPV is positive for scenario 1 and 2 both. We can also conclude that NPV is
sensitive to the revenues and with an increase in revenues by 20%, the NPV increases by
2.5% showing a lower change in NPV as compared to a change in revenues. Even in the two
scenarios, the payback period, IRR and PI is favourable.
Since the NPV of the project is positive and the other capital budgeting techniques are
favourable under all the scenarios, it is recommended that Riverlea Limited should go ahead
with supplying confectionary to Wowcoles under a private label and to purchase new
machinery required to fulfil the increased production levels.
Part 2
Introduction
Efficient market hypothesis (EMH) states that a stock is always correctly priced in the sense
that all publicly available information about the stock is factored into the price of the stock
and hence no investor can have abnormal gains from any analysis like fundamental or
technical analysis (Clarke, Jandik & Mandelkar n.d.)There are three forms of market
hypothesis that are said to exist like Strong form EMH, semi strong form and weak form
EMH. According to weak form EMH, the prices of stock have all past information
incorporated into it. Semi weak form suggests that all new information is immediately

incorporated into the stock price and under strong form, both public and private information
is incorporated into the stock prices and no investor can gain advantage (Sandhar, Nathani &
Holani 2009)
Findings
The stock price movement for five days before the announcement and five days after for
Riverlea Limited has been presented in a graphic form below.
Day -5 -4 -3 -2 -1 0 1 2 3 4 5
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Stock Price($)
Stock Price($)
From the above we see that the stock price is in the range of $1.2 till four days prior to the
announcement, it has increased by 80% one day prior to the announcement and on the day of
the announcement the stock price has increased by about 100%. Thereafter the price has
fallen by 1.8% the next day of the announcement and has increased by 1.7% on the second
day of the announcement. In general, for the next five days, the stock price has fallen by
approx. 1.5% but has remained in the range of $4.2 to $4.3. A similar pattern was being
followed prior to the announcement.
Conclusion and Recommendation
As a result of the new project, the increase in per share price should be $6.86 (NPV value /
number of shares) and therefore the increase in stock price on the day of the announcement
should be by $6.86 according to the semi strong form EMH as the hypothesis assumes that all
publicly available information is incorporated into the share price. However, here this is not
the case as the share price has increased by 80% one day prior to the announcement which
shows some insider information caused the prices to increase and on the day to the

announcement the prices further increased by 100% or by $2.19. The total increase in share
price due to announcement is $3.15 and the increase has happened in two days’ time. The
increase in share price less than expected by $3.71. This means the share price of Riverlea
Limited does not reflect its intrinsic value and hence we can say the shares are undervalued.
Moreover, the share prices have fallen by 1.8% on next day of announcement and have
increased by 1.2% on the second day, this shows adjustment of the price as investors buy and
sell the shares.
As we see that the share prices do not reflect the actual intrinsic value, we can expect the
share prices to rise in the future, hence it is recommended to buy the shares of Riverlea as the
prices are expected to rise. Moreover, since semi strong form EMH is said to exist, we will
see that when more and more investors will buy the shares of the company, the price of the
stock will increase till the level it truly reflects its intrinsic value. Thereafter, the EMH will
exist.
Bibliography
Clarke, J, Jandik, T & Mandelkar, G, Efficient Market Hypothesis, viewed 5 October 2017, <http://m.e-
m-h.org/ClJM.pdf>.
Sandhar, S, Nathani, N & Holani, U 2009, 'TESTING SEMI-STRONG FORM OF MARKET EFFICIENCY: A
Study of NSE', Appejay Journal of Management and Technology , vol 4, no. 1.