Capital Budgeting and Corporate Finance Analysis for Riverlea

This report provides a comprehensive analysis of Riverlea's capital budgeting project, focusing on the expansion of the company. The report is divided into two parts. The first part examines capital budgeting techniques, including the calculation of Net Present Value (NPV) under different scenarios and the application of the Capital Asset Pricing Model (CAPM) to determine the cost of equity. The second part analyzes the stock price movement of Riverlea in response to the announcement of the capital-intensive project, evaluating the impact of the announcement on stock prices and the beta of the firm. The analysis includes calculations of initial costs, depreciation, cash flows after tax (CFAT), and discounting factors to assess the profitability of the investment. The report concludes with recommendations for the firm, emphasizing both financial and non-financial factors to consider for successful project implementation and long-term sustainability. The findings suggest the project is profitable and that the announcement had a positive impact on the stock price.

Running head: Capital Budgeting and Corporate Finance
Student name:
Capital Budgeting and Corporate Finance
Institute Name:
Affiliation:
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Running head: Capital Budgeting and Corporate Finance
Executive Summary
Capital budgeting may be considered to be one of the most success critical elements in corporate
finance. The management of every business firm should carefully consider the matter before
finalising the corporate strategy. The report deals with one of such examples of a firm, Riverlea
which is into an expansion mode and considering investment in a capital intensive project. The
report is dividend in two parts. The first part shows the capital budgeting technique and related
evaluation and analysis. The second part shows the stock price movement and related analysis.
Finally, the report provides recommendation.
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Running head: Capital Budgeting and Corporate Finance
Table of Contents
Part 1................................................................................................................................................4
Introduction..................................................................................................................................4
Findings........................................................................................................................................4
Conclusions and Recommendations............................................................................................7
Part 2................................................................................................................................................8
Introduction..................................................................................................................................8
Findings........................................................................................................................................8
Conclusions and Recommendations..........................................................................................10
References......................................................................................................................................11
Appendices....................................................................................................................................12
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Running head: Capital Budgeting and Corporate Finance
Part 1
Introduction
The current part of the assignment pertains to computations regarding capital budget and for
investment appraisal of Riverlea. In this part, the investment upon machinery as a part of the
company's business expansion has been examined using capital budget techniques. Daunfeldt
and Hartwig (2014) mentioned that capital budgeting techniques examined the expected earnings
and revenues generated from a particular investment proposition using a host of parameters.
These parameters range from initial capital investment, expected depreciation to cash flows
generated and expected present value of the returns from the investments. In the current analysis,
a detail financial analysis has been undertaken using discounting factors and expected cash flows
for generation of net present value under three situations. Moreover, Capital Asset Pricing Model
has been utilized in the current study through computations of beta, risk-free rates and thereby
the degree of volatility showcased by River-lea's stock. Rossi (2014) mentioned that CAPM
model takes into account systematic risk pertaining to stocks and thereby assists investors in
undertaking buying or sell off decisions based upon their individual risk propensities.
Findings
There have been three situations provided for the analysis of investment decisions in the current
study. This includes the expected revenues generated from the data provided in the assignment
and changes in revenues from year 6 onwards.
At the beginning of the study, the effort has been made to calculate the initial cost and
corresponding depreciation. Installation and shipping cost has been added to the purchase cost to
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Running head: Capital Budgeting and Corporate Finance
arrive at the total initial cost of the project. In this context, it may be noted adjustment for
investment in working capital has been performed with the cash flow. Only, the initial
investment of $50,000 has been considered in the initial cost calculation. Total cost, thus, comes
to $17, 50,000. Depreciation has been calculated as per reducing balance method.
On the other hand, revenue has been adjusted for the variable costs to arrive at the contribution
figure year wise. Loss of operating revenue and operating costs may be construed to be the fixed
cost for the given purpose. Depreciation has been adjusted against the profit figure and 30% tax
rate has been applied to the profit figure. Investment in working capital has also been adjusted
for the cash flow after tax (CFAT) figure.
In the subsequent part of the study, cost of equity has been calculated. Since the given firm is an
all-equity firm, cost of equity would mean overall cost of capital for the business. In other words,
cost of equity may be considered to be the discounting rate for the purpose of evaluating the
aforesaid capital investment project. In this context, it may be noted that the beta has been
calculated from the data related to movement in the price of both the stock and the market index.
In addition, price data has been provided for G-Bond based on which risk-free rate of return has
been averaged to apply CAPM (capital asset pricing model). Once all the data has been
collected, CAPM may be applied to find out the cost of equity for the firm. The table below in
appendices shows that the discounting factor may be estimated to be 2.54% approximately.
Based on the calculated CFAT and also the discounting rate, the present value of all cash flow
has been calculated in the table attached in the appendices below. However, the table herein
shows the consolidated figure for 10 years, which depicts that the project is profitable with
positive NPV. The project has positive NPV in all probabilistic circumstances. In a normal
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Running head: Capital Budgeting and Corporate Finance
scenario, the project provides a positive NPV of $2,629,361, whereas, considering all the
probabilities, still the project renders NPV to the extent of more than $2.1 million.
Calculation of Net Present Value (NPV)
Particulars Situation 1 Situation 2 Situation 3
Amount $ Amount $ Amount $
Incremental Operating Revenue 12,749,940 9,603,596 14,323,112
Less: Incremental Variable Costs 5,099,976 3,841,438 5,729,245
Incremental Contribution (A) 7,649,964 5,762,157 8,593,867
Decrease in Operating Revenue 2,000,000 2,000,000 2,000,000
Less: Decrease in Operating Cost 800,000 800,000 800,000
Incremental Fixed Cost (B) 1,200,000 1,200,000 1,200,000
Incremental Profit Before Depreciation & Tax (A-B) 6,449,964 4,562,157 7,393,867
Less: Depreciation 1,517,464 1,517,464 1,517,464
Incremental Profit Before Tax 4,932,500 3,044,694 5,876,403
Less: Tax @ 30% 1,479,750 913,408 1,762,921
Incremental Profit After Tax 3,452,750 2,131,286 4,113,482
Add: Depreciation 1,517,464 1,517,464 1,517,464
Cash Flow After Tax (CFAT) 4,970,214 3,648,749 5,630,946
Less: Investment in Working Capital -250,000 -250,000 -250,000
Net CFAT 5,220,214 3,898,749 5,880,946
Discounting Factor 8.7326 8.7326 8.7326
Present Value (PV) 4,379,361 3,302,882 4,917,600
Probability 100% 40% 10%
Probability Adjusted PV 4,379,361 3,948,769 4,433,185
Less: Initial Investment 1,750,000 1,750,000 1,750,000
NPV 2,629,361 2,198,769 2,683,185
Table 1: NPV under the different situations
(Source: Created by author)
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Running head: Capital Budgeting and Corporate Finance
Conclusions and Recommendations
Based on the discussion and analysis performed in the preceding sections of the report, it may be
construed that the firm should accept the project as the same is rewarding and profitable.
However, it may be noted that the management of Riverlea should focus on other non-financial
factors such as HR policies, operational efficiencies, legal framework and other market-related
externalities which may affect the profitability of the aforementioned capital intensive project.
Besides, the management should always consider having a vigilance and check on the activities
in the market and economy front so as to validate or revise the assumptions behind the financial
modeling.
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Running head: Capital Budgeting and Corporate Finance
Part 2
Introduction
Stock price movement may be construed to be one of the most critical factors for the
management to assess, evaluate and decide on the relevant strategies (Grob, 2013). This section
of the assignment deals with the analysis of repercussions of the announcements that have been
made with regards to the business expansion prospects of Riverlea. The observations pertaining
to the stock prices before, after and on the day of the announcement has been examined in the
report as well as the degree of riskiness and volatility observed in case of the company’s stocks.
Findings
As previously discussed, the beta of the firm has been calculated to be -0.56. In this context, it
may be interesting to note that the value of beta has a direct effect on the stock price movement.
Beta may be defined to be a riskiness or volatility of a stock in relation to the market. In other
words, the beta denotes the sensitivity of a stock with reference to the market index. A beta with
1 establishes the fact that the stock price changes in the same direction with that of the market.
Therefore, a negative beta suggests that the stock price moves in the opposite direction as
compared to the market index. If the market falls, the stock price will increase and vice versa
(Abor, 2017).
There have been theories on the semi-strong form of the market which denotes that the stock
price encompasses most of the publicly available information but not all and hence, there
remains a probability for the investors to have insider's insight and leverage the same
accordingly. The semi-strong market is a variation of Efficient Market Hypothesis (EMH) which
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Running head: Capital Budgeting and Corporate Finance
defines an ideal market that captures all the information and market data about the stock into the
market price of the stock.
The stock price movements as can be showcased from the diagram below.
Day -5 Day -4 Day -3 Day -2 Day -1 Day 0 Day 1 Day 2 Day 3 Day 4 Day 5
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00
1.20 1.23 1.16 1.20
2.16
4.35 4.27 4.32 4.25 4.18 4.25
Stock Price ($)
Figure 1: Stock Price Movement
(Source: Created by the author)
In the instant case, it has been observed that the announcement about undertaking the capital-
intensive project has a positive impact on the stock price. Few days before the announcement has
witnessed a comparatively lower price level with an average of $1.39; whereas, the day of the
announcement has experienced more than 100% increase from $2.16 to $4.35 and the same price
level has continued for next few days as well. The diagram that has been showcased above
represents that the price movements of the company's stocks have responded positively in terms
of the announcements. Thereby, this is showcasing a positive reaction and optimism by the
investors and stock market participants regarding the prospects of the company. The above
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Running head: Capital Budgeting and Corporate Finance
diagram showcases that the stock prices were showcasing an upsurge before the day of the
announcement and it can occur owing to market speculation regarding the possible business
expansion by the company.
The above table showcases quantification of the degree of changes that the stock of the company
has been subjected to prior and posts the announcement. The above table showcases a jump in
the share price of 80% prior to the day of the announcement as the speculations of the
announcement has created a demand for the company’s shares. This can be attributed from the
fact that the announcement shall result in the betterment of revenue generation for the company
thus resulting in prospective financial benefits for the longer run.
Conclusions and Recommendations
From the detailed discussion and analysis performed herein, it may be concluded that the stock
price changes for various reasons. It is not necessary the financial performance of the firm that
influences the movement in the price level of stock of the firm. Investors keep a constant
observation on the merger or acquisition-related announcements, announcements related to
management, dividend announcements etc. However, the management should consider the
financial performance of the company so as to achieve the sustainability in the long run with a
strong fundamental growth setting aside the short or mid-term volatility in the market.
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Running head: Capital Budgeting and Corporate Finance
References
Abor, J.Y., (2017). Evaluating Capital Investment Decisions: Capital Budgeting.
In Entrepreneurial Finance for MSMEs (pp. 293-320). Springer International Publishing.
Daunfeldt, S.O. and Hartwig, F., (2014). What determines the use of capital budgeting methods?
Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), pp.101-112.
Grob, H.L., (2013). Capital budgeting with financial plans: an introduction. Springer-Verlag.
Rossi, M., (2014). Capital budgeting in Europe: confronting theory with practice. International
Journal of Managerial and Financial Accounting, 6(4), pp.341-356.
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Running head: Capital Budgeting and Corporate Finance
Appendices
Particulars Amount $
Purchase Cost 1,500,000
Add: Installation & Shipping Cost 200,000
Total Cost 1,700,000
Add: Working Capital 50,000
Total Initial Cost 1,750,000
Calculation of Initial Cost
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