[soneeya1]

Finance Management: Assignment 1

Capital Budgeting

Sporty Fashion Ltd (SF) is a local retailer and manufacturer of sports wear and sports gear. Due to the increased competition, SF is considering implementing the following 3 projects to upgrade and/or expand its current operations. SF has set aside $400,000 for investment in the new projects and wants to recover the initial cost of investment within 5 years. SF's cost of capital is 8%.


Project A: Introduction of a new trendy sport fashion line

After spending $100,000 in market research, SF intends to introduce a new trendy sport fashion line which will require an immediate investment of $50,000 in fashion designing and $250,000 to replace the old production machines. It will cost $25,000 to ship the new machines and another $30,000 for installation. SF will need to incur an annual cost of $18,000 to maintain the new machines (there is no such maintenance costs for the old machines, as it is almost obsolete and will be disposed of, if it should breakdown).


Project B: Establishment of an Online Store

Currently, SF retails its products through its retail stores. SF is looking at creating an online store which will reside on computer servers costing $75,000 purchased 3 months ago. There will be a development fee of $40,000 for establishing the online store.


Project C: Refurbishment of an existing building

SF intends to refurbish an existing building that it owns into a new flagship store for its operations. The cost of the refurbishment is expected to be $350,000. The existing building is currently rented to J'line Jewelry under a lease agreement that will run for another 5 years at an annual rental of $36,000. The lease can be cancelled by paying 3 months' rental now. If the refurbishment project goes ahead, the rental from J'line Jewelry will be foregone.



The above projects are expected to generate cash inflows for the next 5 years as shown in Table 1 below:

Table 1: Cash inflows projection for the 3 projects



Cash Inflows

Project A
New trendy sport fashion line

Year 1 Cash Flows 165,000
Year 2 Cash Flows 140,000
Year 3 Cash Flows 100,000
Year 4 Cash Flows 95,000
Year 5 Cash Flows 80,000


Project B

Retail stores without online store
Year 1 380,000
Year 2 420,000
Year 3 480,000
Year 4 560,000
Year 5 600,000


Retail stores with the online store
Year 1 385,000
Year 2 430,000
Year 3 493,000
Year 4 582,000
Year 5 628,000



Project C
New Flagship Store
Year 1 100,000
Year2 145,000
Year3 170,000
Year 4 155,000
Year 5 120,000




Whilst management is relatively confident about the cash flow projections above, they are also aware that unforeseen events such as global downturn and possible economic recession may impact the above projections.

In your paper, you have to:

1. Use the various investment evaluation methods, evaluate which project SF should implement to maximize the wealth of its shareholders based on the projected cash flows.

2. Justify your choice of evaluation methods and your recommendation.

3. Advise SF on the methods of better management of risks and uncertainties for such decision making purposes.

[soneeya1]

Project A
Interest: 8%
Year Adjusted Cashflow Payback Method PV
0 ($355,000.00) ($355,000.00) ($355,000.00)
1 $147,000.00 ($208,000.00) $136,111.11
2 $122,000.00 ($86,000.00) $104,595.34
3 $82,000.00 ($4,000.00) $65,094.24
4 $77,000.00 $73,000.00 $56,597.30
5 $62,000.00 $42,196.16
Total PV $404,594.15

Payback Method = 3.05yrs
NPV = $49,594.15
IRR = 14.13%
PI = 1.14

Project B
Interest: 8%
Year Adjusted Cashflow Payback Method PV
0 ($40,000.00) ($40,000.00) $(40,000.00)
1 $5,000.00 ($35,000.00) $4,629.63
2 $10,000.00 ($25,000.00) $8,573.39
3 $13,000.00 ($12,000.00) $10,319.82
4 $22,000.00 $10,000.00 $16,170.66
5 $28,000.00 $19,056.33
Total PV $58,749.82

Payback Method = 3.55yrs
NPV = $18,749.82
IRR = 20.43%
PI = 1.47

Project C
Interest: 8%
Year Adjusted Cashflow Payback Method PV
0 ($359,000.00) ($359,000.00) ($359,000.00)
1 $64,000.00 ($295,000.00) $59,259.26
2 $109,000.00 ($186,000.00) $93,449.93
3 $134,000.00 ($52,000.00) $106,373.52
4 $119,000.00 $67,000.00 $87,468.55
5 $84,000.00 $57,168.99
Total PV $403,720.25
Payback Method = 3.44yrs
NPV = $44,720.25
IRR = 12.4%
PI = 1.12


I don't know if this is right if so how do I advise using financial terms?

Thanks..

[ArcSine]

Soneeya, all 12 of your calcs (3 projects; 4 metrics each) are spot on... nice job!

The background info says we've got 400K to spend on new projects. Even though your Question 1 says "... which project... " (singular), I'd bet they've got in mind a capital rationing decision, in which you're to select an optimal mix of projects.

Given the initial outlay requirements, you can take either A and B, or B and C.

Since the decision should be based on an objective of maximizing aggregate NPV, then it's easy to see which of those two project combos gives the largest aggregate NPV.

You'd also get the same answer if you used profitability index as your decision criterion. Put 'em in descending order according to PI, then starting at the top, take every project going down the list until you don't have enough money left in the kitty to take another project.

As to your second question, you'll find in your text a discussion of why NPV is the rational choice, over payback, and even over IRR.

With respect to the third question, you should address the issue of whether the firm's overall COC is appropriate for NPV'g these projects. When I hear words like "increased competition" (background info) and "new trendy sport fashion line" (Project A), I immediately think "increased risk".

[soneeya1]

Soneeya, all 12 of your calcs (3 projects; 4 metrics each) are spot on...nice job!

The background info says we've got 400K to spend on new projects. Even though your Question 1 says "...which project..." (singular), I'd bet they've got in mind a capital rationing decision, in which you're to select an optimal mix of projects.

Given the initial outlay requirements, you can take either A and B, or B and C.

Since the decision should be based on an objective of maximizing aggregate NPV, then it's easy to see which of those two project combos gives the largest aggregate NPV.

You'd also get the same answer if you used profitability index as your decision criterion. Put 'em in descending order according to PI, then starting at the top, take every project going down the list until you don't have enough money left in the kitty to take another project.

As to your second question, you'll find in your text a discussion of why NPV is the rational choice, over payback, and even over IRR.

With respect to the third question, you should address the issue of whether the firm's overall COC is appropriate for NPV'g these projects. When I hear words like "increased competition" (background info) and "new trendy sport fashion line" (Project A), I immediately think "increased risk".

Dear ArcSine,

Thank you for the reply :)

Unfortunately I don't think I know how to put them in descending order for question one and as for the third question I am supposed to write about three hundred words to address the issue, I'm lost totally... Hope you'll be able to assist me.. I was able to do the calculations because of the formulas and using excel was a breeze but Im lost right after that :( help..

[ArcSine]

Question 1 asks you to decide which project or project(s) to sink the available 400K into. Clearly the 400K would cover either A and B, or C and B. (The A and C combo is out of the running, since their combined initial cost exceeds your budget.)

You can easily see which of those two pairs gives the higher total NPV.

Using the PI decision criterion would give you the same answer. Putting the 3 projects into descending order by PI gives this order: B (1.47); then A (1.14); finally C (1.12).

Having done that, you start at the top of the list and accept the first project (B). You've now spent 40K of the 400K. On to the next one (A). Can you accept it? Yes... you've got 360K left to spend, and A costs only 355K. On to the final one (C). Can you accept it? Nope... after taking B and A there's only 5K left in the kitty.

For the third question, here's a fundamental concept to get the ball rolling: The discount rate used in evaluating a project's expected NPV should be a rate which is appropriate for the level of uncertainty (risk) inherent in the project. The firm should only use its overall COC in discounting these projects if these projects have the same risk level as that of all the firm's other projects and assets.

This is unlikely. The company's existing assets and projects have established cash flow and earnings track records, whereas these new projects under consideration are unproven ventures.

A direct spin-off of that idea is that projects should only be PV'd using the same discount rate if they have the same uncertainty levels. Again, unlikely... each project should be PV'd with a unique discount rate appropriate to the risk level of that project.

That just sets the table for you--you'll have to cook the 300-word meal yourself. But it gives you a key ingredient to play with. Check your text--and Google around--for "capital budgeting", especially with respect to the selection of discount rates.

Good luck!

[soneeya1]

Question 1 asks you to decide which project or project(s) to sink the available 400K into. Clearly the 400K would cover either A and B, or C and B. (The A and C combo is out of the running, since their combined initial cost exceeds your budget.)

You can easily see which of those two pairs gives the higher total NPV.

Using the PI decision criterion would give you the same answer. Putting the 3 projects into descending order by PI gives this order: B (1.47); then A (1.14); finally C (1.12).

Having done that, you start at the top of the list and accept the first project (B). You've now spent 40K of the 400K. On to the next one (A). Can you accept it? Yes...you've got 360K left to spend, and A costs only 355K. On to the final one (C). Can you accept it? Nope...after taking B and A there's only 5K left in the kitty.

For the third question, here's a fundamental concept to get the ball rolling: The discount rate used in evaluating a project's expected NPV should be a rate which is appropriate for the level of uncertainty (risk) inherent in the project. The firm should only use its overall COC in discounting these projects if these projects have the same risk level as that of all the firm's other projects and assets.

This is unlikely. The company's existing assets and projects have established cash flow and earnings track records, whereas these new projects under consideration are unproven ventures.

A direct spin-off of that idea is that projects should only be PV'd using the same discount rate if they have the same uncertainty levels. Again, unlikely...each project should be PV'd with a unique discount rate appropriate to the risk level of that project.

That just sets the table for you--you'll have to cook the 300-word meal yourself. But it gives you a key ingredient to play with. Check your text--and Google around--for "capital budgeting", especially with respect to the selection of discount rates.

Good luck!

Dear ArcSine,

Thank you! That was clear and it was such a great help:) thank you once again..

[ArcSine]

It was a pleasure. And since you scored a perfect 12-for-12 on those calculations, the smart money says you're going to do well. Take care,

[soneeya1]

It was a pleasure. And since you scored a perfect 12-for-12 on those calculations, the smart money says you're gonna do well. Take care,

Awww thank u ArcSine for the vote of confidence :) You take care too.. you are so kind ;)