Finance Memorandum: Proposed Project Evaluation for Pinto Limited

This finance memorandum, addressed to the CEO of Pinto Limited, presents an analysis of a proposed project in the face of increasing competition. The analysis incorporates key assumptions and considers sunk costs, opportunity costs, and depreciation. It calculates Net Present Value (NPV), Internal Rate of Return (IRR), payback period, discounted payback period, and Profitability Index (PI) to assess the project's financial viability. The report also includes scenario and sensitivity analyses to account for uncertainty, examining optimistic and pessimistic scenarios, and the impact of growth and discount rates on NPV. Based on the results, the memorandum recommends undertaking the project, highlighting its positive NPV, favorable IRR, and other positive indicators, concluding the project is financially feasible and creates value for shareholders.

FINANCE
MEMORANDUM
STUDENT ID:
[Pick the date]

MEMORANDUM
From: STUDENT NAME
To: CEO, Pinto Limited
Date: 15th May, 2018
Subject: Proposed Project Evaluation (CONFIDENTIAL)
Dear Sir
The objective of this memo is to conduct an analysis of the proposed project in view of the
increasing competition. The critical aspects and assumptions undertaken for the analysis of
the project are illustrated as follows.
1) A feed to the extent of $ 25,000 has been spent on the market analysis which has been
conducted by an external consultant. This amount would be ignored from the
computations as only incremental cash flows are imperative. However, the given cost is
sunk cost since it cannot be recovered even if project is not gone ahead with.
(Damodaran, 2015).
2) Also, the opportunity cost in relation to the current building has been considered. The
reason behind the same is that if this building is used for the given project that the rent
income to the extent of $ 250,000 per year would not be realised. Hence, this amount is an
incremental loss on account of the project (Northington, 2015).
3) It is known that the initial spending on plant and equipment would be $ 15 million and the
expected salvage value at the end of the useful life is expected to be zero. In such a
scenario, the straight line depreciation would amount to $ 3 million on an annual basis.
4) The incremental working capital that would be required would be investment at the project
beginning.
5) Besides, considering that the various capital budgeting measures are based on discounted
cash flows and hence assumption has been made that the cash flows arising from the
project are realised at the last day of the year.
For the application of the above capital budgeting techniques, the key requirement is that
incremental cash flows expected from the project need to be estimated considering the
information provided. The incremental cashflows are illustrated as follows.

Having estimated the expected project cash flows over the useful life, the various capital
budgeting techniques would be applied so as to enable making a conclusion with regards to
undertaking the project.
1) NPV (Net Present Value)
NPV = $ 5.6 million.
2) IRR (Internal Rate of Return)
The IRR has been computed using the cash flows estimation provided above (Brealey, Myers
and Allen, 2014).
IRR = 21.13% p.a.
3) Payback Period
The computation indicated as follows are helpful for payback period determination
(Damodaran, 2015).

Therefore, payback period can be calculated as 2+ (7.3/9.98) or 2.73 years
4) Discounted Payback Period
The computation indicated as follows are helpful for discounted payback period
determination (Parrino and Kidwell, 2014).
Therefore, discounted payback period can be calculated as 3 + (1.31/3.47) or 3.38 years
5) Profitability Index
Profitability Index = (PV of future cash inflows from project/Initial Investment) = (23.6/18)
or 1.31
Uncertainty Analysis
To account for potential uncertainty with regards to the expected product demand and other
factors, it is essential to conduct an uncertainty analysis using both scenario and sensitivity
analysis.
Scenario Analysis
The key possible scenarios are highlighted below.
1) Pessimistic Scenario (Probability = 30% )
 Product acceptability low
 Growth rate in Year 2 & 3 slowed to 25%
 Subsequent decline rate in Year 4 &5 increased to 60%
 Pricing power lower and hence 2% increase in prices on a y-o-y basis
2) Optimistic Scenario (Probability = 30%)

 Product acceptability high
 Growth rate in Year 2 & 3 hiked to 75%
 Pricing power higher and hence 4% increase in prices on a y-o-y basis
The summary of the computations is contained below.
Sensitivity Analysis
This considers the impact of two main factors namely the growth rate in sales witnessed in
Year 2 $ 3 and also the discount rate. The graph highlighting the relationship between NPV
and these factors is shown below.
It is apparent from above that there is a significant leeway in both the factors so as to ensure
that the NPV of the project remains positive (Damodaran, 2015).
Recommendations (Project Feasibility)
On the basis of the results of the various capital budgeting techniques obtained above, it
would be appropriate to recommend that the proposed project must be undertaken by the
company owing the reasons mentioned below (Brealey, Myers and Allen, 2014).

1) The project NPV is positive and hence project would create value for the shareholders.
2) As the project IRR exceeds the cost of capital for the project, hence project is feasible in
financial terms.
3) The useful life of the project exceeds the payback period computed for the project.
4) The useful life of the project exceeds the discounted payback period computed for the
project.
5) PI has been indicated as exceeding 1 thus highlighting the project’s financial feasibility.
6) The scenario analysis indicates that the estimated project NPV is positive.
7) The sensitivity analysis highlights that despite NPV being impacted by the discount rate
and growth rate (sales volume), there is enough leeway available for ensuring that NPV
stays positive.
If there are any queries on any aspect related to the project, please write back and I will be
happy to clarify any queries you may have in this regards.
Yours Sincerely
STUDENT NAME
References
Brealey, R. A., Myers, S. C., & Allen, F. (2014) Principles of corporate finance, 2nd ed. New
York: McGraw-Hill Inc.

Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
Northington, S. (2015) Finance, 4th ed. New York: Ferguson
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015).
Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French
Forest Australia.