Corporate Finance Investment and Financing Decisions Report

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Corporate Finance
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Table of Contents
Introduction.................................................................................................................................................3
Part A- Investment Decision........................................................................................................................4
Part B- Financing Decisions......................................................................................................................11
Conclusion.................................................................................................................................................12
References.................................................................................................................................................13
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Introduction
This assignment has been made to gain an understanding of the investment decision by
evaluation of the project. Various techniques have been implemented in this assignment for
analysis of the project for capital appraisal like Net present value, IRR, Payback Period and
Profitability Index. Then the analysis on the basis of the same is made and accepted for the
project is provided in this assignment. In part B of the assignment details relating to financing,
decisions have been let down with the explanations of the various theories given by Modigliani
and Miller. Details about dividend policy and capital structure have also been provided in part B
of the assignment.
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Part A- Investment Decision
Blue Mountain is considering the evaluation of the proposed project about whether the project is
beneficial for the organization or not. Various capital appraisal techniques have been used to
determine whether such a project is beneficial or not. The analysis of the project has been done
as follows:
Calculation of Cash Inflows during the 5 Year period of the project
Particul
ars Year 1 Year 2 Year 3 Year 4 Year 5
Sales
Revenue
from
New
Product
$
2,000,000
$
4,000,000
$
6,000,00
0
$
8,000,00
0
$
10,000,0
00
Sales
Revenue
Increase
from old
product
$
1,571,429
$
1,571,429
$
1,571,42
9
$
1,571,42
9
$
1,571,42
9
Saving
by using
Waste
Product
$
90,000
$
90,000
$
90,000
$
90,000
$
90,000
Total
Increme
ntal
Revenue
$
3,661,429
$
5,661,429
$
7,661,42
9
$
9,661,42
9
$
11,661,4
29
Less:
Operati
ng
Expense
$
500,000
$
1,000,000
$
1,500,00
0
$
2,000,00
0
$
2,500,00
0
Less:
Other
Expense
s
Advertis
ment
Expense
$
500,000
$
500,000
$
500,000
$
500,000
$
500,000
Interest
Expense
$
1,100,000
$
1,100,000
$
1,100,00
0
$
1,100,00
0
$
1,100,00
0
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Opportun
ity
Cost( for
storage
capacity)
$
90,000
$
90,000
$
90,000
$
90,000
$
90,000
Deprecia
tion
$
2,360,000
$
2,360,000
$
2,360,00
0
$
2,360,00
0
$
2,360,00
0
Total
Expenses
$
4,550,000
$
5,050,000
$
5,550,00
0
$
6,050,00
0
$
6,550,00
0
Inflow
Flow
before
tax
$
(888,571)
$
611,429
$
2,111,42
9
$
3,611,42
9
$
5,111,42
9
Less/
Add:
Tax/Tax
Benefit
@ 30%
$
266,571
$
183,429
$
633,429
$
1,083,42
9
$
1,533,42
9
Inflow
Flow
After
Tax
$
(622,000)
$
428,000
$
1,478,00
0
$
2,528,00
0
$
3,578,00
0
Add:
Deprecia
tion
$
2,360,000
$
2,360,000
$
2,360,00
0
$
2,360,00
0
$
2,360,00
0
Cash
Inflow
After
Tax
from
operatio
ns
$
1,738,000
$
2,788,000
$
3,838,00
0
$
4,888,00
0
$
5,938,00
0
Add:
Salvage
Value at
the End
of Year
5
$
1,200,00
0
Add:
Increase
in
Working
Capital
$
500,000 Total
Total $ $ $ $ $ $
5

Cash
Inflow 1,738,000 2,788,000
3,838,00
0
4,888,00
0
7,638,00
0
20,890,0
00
PVF
@9%
$
0.917
$
0.841
$
0.772
$
0.708
$
0.650
Present
Value of
Cash
Flow
$
1,593,746
$
2,344,708
$
2,962,93
6
$
3,460,70
4
$
4,964,70
0
$
15,326,7
94
Calculation of Cash Outflow from the project
Particulars Amount
Cost of Machine $ 13,000,000
Working Capital $ 500,000
Total Cash Outflow $ 13,500,000
Capital Appraisal Techniques
1. Net Present Value: This method helps in comparing the present value of cash inflows
with the present value of cash outflow. NPV is the difference between the present value
of cash inflow and cash outflow during the life of the project (Leyman & Vanhoucke,
2017). If NPV is positive then it is beneficial for the organization and the project should
be accepted whereas if the NPV is negative then the project should not be undertaken.
NPV = Present Value of Cash Inflow- Present Value of Cash Outflow
Net Present Value
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Present Value of Cash Inflow $ 15,326,794
Cash Outflow $ 13,500,000
Net Present Value $ 1,826,794
2. Profitability Index: It is a type of index which helps in identifying the relationship
between the cost and benefits occurring from a particular project. If the profitability index
for the project is less than 1 then the same should not be accepted by the company
whereas if the same is more than 1 then the project should be accepted
(corporatefinanceinstitute, 2019). The profitability index is computed by dividing the
present value of cash inflow by Initial investment.
Profitability Index = PV of Cash Inflow/Initial Investment
Present Value of Cash Inflow $ 15,326,794
Initial Investment $ 13,500,000
Profitability Index 1.135
3. Payback Period: It indicates the period in which the amount invested in a particular
project can be recovered from the cash inflows of the project. If the amount initially
invested and incurred during the period is recovered during the duration of the project
then the project is feasible and should be accepted. If the amount cannot be recovered
during the projected life of the project then the project should not be accepted.
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Year Annual Cash Inflow Cumulative Cash Inflow
1 $ 1,593,746 $ 1,593,746
2 $ 2,344,708 $ 3,938,454
3 $ 2,962,936 $ 6,901,390
4 $ 3,460,704 $ 10,362,094
5 $ 4,964,700 $ 15,326,794
Payback Period= 4 Years + (3137906/4964700)
Payback Period= 4.632 Years
4. Internal Rate of Return: Internal rate is the rate of the project where the present value
of cash inflow is equal to the present value of cash outflow. This method is used in the
analysis of the investments and its profitability (Santandrea, et. al., 2017). It also shows
the time in which the amount is recovered by the project.
Particulars Amount (Inflow/Outflow)
Year 0 $ (13,500,000)
Year 1 $ 1,593,746
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Year 2 $ 2,344,708
Year 3 $ 2,962,936
Year 4 $ 3,460,704
Year 5 $ 4,964,700
Internal Rate of Return 3.72%
Notes
 It has been assumed that the research cost related to environmental impact study and new
product amounting to $ 250000 & $ 800000 respectively have been sunk and not
considered under cash outflow for Blue Mountain Ltd.
 Storage Capacity owned by the company that could be rented is considered as
opportunity cost thus is deducted while computing the incremental revenue from the
project.
 Saving in the raw material purchase is considered as incremental revenue for Blue
Mountain Ltd
 It has been assumed that the advertisement cost of $ 2500000 has been evenly distributed
in the 5 years of the economic life of the project
 Depreciation on the machinery is computed on the cost of the machine by subtracting the
salvage value and taking the useful life as 5 years for the machinery.
 The increase in net working capital would again be reduced in year 5 thus effect of the
same is shown at the end of year 5 while computing the present value of cash flow.
 Operating expense is considered to be 25% of the sales revenue generated from the new
product.
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 The weighted average cost of capital is considered to be 9% for the proposed project as
risk is higher in the proposed project.
 Sale of the product already selling in the market is increased by $ 1100000 after tax but
the effect of the same is given while computing cash inflow taking such sale as before tax
and removing the effect of 30% tax on the same as shown above.
Analysis of the project
From the overall analysis of the project, it can be determined that the project should be
undertaken by Blue Mountain Ltd as the capital project that has been appraised by various
techniques like NPV, IRR, Payback period and profitability index. It shows the following
results:
NPV: As the NPV computed above is positive thus the project should be accepted from the
point of view of NPV.
Payback Period: As the cash outflow from the project is covered within the overall duration
of the product thus the product should be accepted as per the Payback period.
Profitability Index: In the case of profitability index as the PI computed is greater than 1
thus the project should be accepted as inflows are able to cover the outflows thus generating
the profit for the company from such a project.
Internal Rate of Return: In case of internal rate of return project should be accepted if the
amount is recovered within a substantial period of time. In the given case it can be seen that
the amount is recovered near to the end of the project thus the project is not favorable in view
of the internal rate of return.
Thus to conclude it can be said that from point of view of NPV, Payback Period and
Profitability Index the project is beneficial and should be accepted. However, from the point
of view of the Internal Rate of Return, the project is not beneficial to be accepted.
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Part B- Financing Decisions
There are various factors that state the irrelevancy of dividend and capital structure with that of
stock prices. Modigliani and Millar have given many theories related to capital structure and
dividend but the irrelevancy of dividends is one of them. MM suggested that if more dividends
are earned by the investor than they can re-invest that amount in stock of the company. In other
scenarios, if in case the organization is earning less dividend then some parts of shares can be
sold off so as to surplus the cash flow. So, in both cases, investors are not relevant to the
dividend policy of the company as they can create their own surplus (Ani, 2016).
Taxes are considered as one of the major factors that need to be researched. M&M considered
taxes as the methodical imperfections in the market. They revised the position of taxes on the
irrelevancy of capital structure by stating that with the involvement of corporate taxes firms
should prefer the capital structure which is 100 percent debt (Anton, 2016). According to M&M,
they assumed that there are no taxes but this cannot be true in the real world. This theory helps in
recognizing the benefits of taxes which are related to interest payments. The interest is salaried
on the funds that are borrowed and is also tax-deductible. The actual cost is less than that of the
nominal cost due to the occurrence of tax benefits (Ani, 2016). It is determined that the
organization can utilize all its requirements with the debts as the cost of bankruptcy, increases
the value of tax benefits.
Hence, the approach of corporate taxes helps in tax savings and also determines that the debt to
equity ratio will have an effect on the weighted average cost of capital. This, in turn, means that
higher the amount of debt lower will be the WACC. Therefore, it can be said that the dividend is
an irrelevance to stock prices as well as the capital structure.
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Conclusion
Thus to conclude it can be said that investment appraisal is an important activity for any
organization as it states whether the organization would benefit from the particular project.
Also, it can be seen in Part A that the project should be accepted as per various project
evaluation as it generates profit by the end of the project period and overall it will generate
income for the organization. In part 2 it can be concluded that as per the theories are given by
Modigliani and Miller there is no effect on the stock price and capital structure of the
particular organization from the dividend policy of that organization thus these are two
separate concepts.
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