Assessment Reference: CF/Jan11/1

Name: Leong Khai Heng, Vivian Page 1 of 11

Student Number: 7640044 Date: 18 April 2011

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Corporate Finance

Course Assessment 1

Name: Leong Khai Heng, Vivian

Student ID: 7640044

Assignment Reference: CF/Jan11/1

Assessment Reference: CF/Jan11/1

Name: Leong Khai Heng, Vivian Page 2 of 11

Student Number: 7640044 Date: 18 April 2011

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Objective/ Expectation

To access a proposal for an investment, it is fundamental to identify the key

points for decision-making. For this project the decision maker is the Managing

Director, which influence the outcome of the project. He has given clear

criteria which uses by him to justify the investment worthy. Here are the 2 key

points: -

1. The project must pay for itself in the first three years.

 This means the payback period must be 3 years or less.

2. The spending of £240,000 on this project makes economic sense.

 This means calculation of NPV, IRR and payback period

Information and Assumptions

1. The product does not have more than four-years-life and will generate

£20,000 in scrap metal at the end of the project.

2. There were 2 options: -

(a) Keep the old machine for 4 years and generate one-time-off of

£8,000 at the end of the 4th year

(b) Discard the old machine at the beginning of the project and

generate immediate £20,000 in scrap metal. This option also will

create £18,000 cash benefits each year.

3. The sunk costs has been taken in consideration the below: -

a. Administration charge

b. Fixed overheads

c. Sales forecast and advertising effort had been planned in

Assessment Reference: CF/Jan11/1

Name: Leong Khai Heng, Vivian Page 3 of 11

Student Number: 7640044 Date: 18 April 2011

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consultation with marketing consultants (£18,000)

4. The operating expenses calculation taken into the consideration where:

a. ‘Other production expenses' were deducted with the apportioned

fixed overheads (equal to 20% of labor costs) that further reduce

the operating profit.

b. Marketing cost at Year 0 (at the start of the project) was £40,000

and a further £8,000 a year for 4 years was included.

5. The required rate of return used in accessing this proposal (in

calculating the NPV) is 10%.

6. The profit loss on competing product is taken into consideration in

calculation the cash flow.

Gross Margin = [Revenue – Cost of Sales]/Revenue

• Given Gross Margin = 25%

• Revenue a year is £60,000

• Revenue-Cost of sales (loss before taxes) = £15,000

Assessment The Proposal

Step 1: Calculate capital allowance

The calculation of capital allowance only considered the CNC machine capital

expenditure. And it is 25% on the reducing balance for tax purposes is to be

noted.
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Name: Leong Khai Heng, Vivian Page 4 of 11

Student Number: 7640044 Date: 18 April 2011

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Step 2: Calculate the change in working capital

Assuming only stock and the opening stock in Year 1 would be acquired at the

same time as the machine. All other stock movement would occur at the year-

end. Thus, Year 0 is included.

Step 3: Calculate taxable profits and taxes payable

Here, we would like to have a separate calculation for 2 options shown in

below for a more accurate profit projection: -

Option (A): Keep old machine for 4 year

Option (B): Discard old machine and generate cash benefit

In order to calculate the taxable profits and taxes payable, the “Overhead

Expenses” were deducted with the allocated fixed overheads (20% of labor

coast).
Assessment Reference: CF/Jan11/1

Name: Leong Khai Heng, Vivian Page 5 of 11

Student Number: 7640044 Date: 18 April 2011

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Marketing cost at Year 0 (at the start of the project) was £40K and a further

£8K a year for consecutive 4 years was included also. Here, we consider the

profit loss as tax saving.

In both options, taxes are only paid in the 3 rd year of the project. However,

considering the discounted cash flow, it shown that discarding the old machine

provides a better tax saving but was not a preferable option by accountant.

Option (A) Keep old machine for 4 years

Option (B) Discard old machine and generate cash benefit

Assessment Reference: CF/Jan11/1

Name: Leong Khai Heng, Vivian Page 6 of 11

Student Number: 7640044 Date: 18 April 2011

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Step 4: Calculate after-tax cash flows

Option (A) Keep old machine for 4 years

Option (B) Discard old machine and generate cash benefit

Assessment Reference: CF/Jan11/1

Name: Leong Khai Heng, Vivian Page 7 of 11

Student Number: 7640044 Date: 18 April 2011

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Step 5: Calculate NPV, Payback Period, IRR and Profitability Index

Option (A) Keep old machine for 4 years

Option (B) Discard old machine and generate cash benefit

Evaluation on the Different Methods

Assessment Reference: CF/Jan11/1

Name: Leong Khai Heng, Vivian Page 8 of 11

Student Number: 7640044 Date: 18 April 2011

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The typically approach to access the worth of a proposal is using payback

method, and return on investment (ROI) which both methods is not able to

convincingly shown the investment is “economical” worth at current stage.

The problem with the payback method is the calculation only shown the length

of time required to recover the cost of investment and ignore any benefits

(specially the profitability) that occur after the payback period. It also does not

project the time value of the money.

On the other end, although ROI is attempting to measure the profitability,

however, it is vulnerable to manipulation by user’s preference.

Hence, to be able provide a more transparent assessment on investment;

discounted cash flow method (NPV) is adopted. Above has shown in detail the

5 steps in calculating the NPV.

Using the NPV in calculation would considering the scale of investment and

provides an indication of the size of the actual cash flow. NPV compares the

value of a dollar today to the value of that same dollar in the future, taking

inflation and returns into account; it takes into the time value of money. This is

a most methodical method to analyse cash flow that directly relates to how a

company is managed. In most cases, at the dynamic economic, measuring the

cost effectiveness by looking at expenses is crucial and keeps company at top

notch among rivals.

From the above assessment on both options, the NPV are both positive. This

would recommend that the investment would yield. However, given the

scenario that if the company is overstretched by large debt payment, a

positive NPV project will also be rejected, as the initial capital will use in
Assessment Reference: CF/Jan11/1

Name: Leong Khai Heng, Vivian Page 9 of 11

Student Number: 7640044 Date: 18 April 2011

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servicing the debt instead of investing in new project.

Hence, we look into calculating the payback period. It is known by the

managing director (for some reason e.g. payment to large debt needed after 3

years) that the payback period have to be less than 3 years. The above

assessment shown that the option (B) discard the old machine fulfilled the

requirement of generating positive NPV with payback period within 3 years.

The assessment further shown that the Internal Rate of Return (IRR) exceeded

the required rate of return, which has been identifying as 10%.

Profitability index has been use in assessing the proposal for the purpose to

better shown the financial attractiveness of the proposed project. Being a

ratio, in comparing the 2 options, it pointedly shown the option B being more

financially attractive to invest.

Conclusion

From the above assessment, we can confidently concluded that the option B,

discard the old machine and uses the new machine, projected a better position

at this current moment of time frame as this project generate more wealth to

the shareholders. Review back on the key points: -

1. The project must pay for itself in the first three years.

 The payback period is 2.91

2. The spending of £240,000 on this project makes economic sense.

 The NPV shown a positive figure of 74.69.

Assessment Reference: CF/Jan11/1

Name: Leong Khai Heng, Vivian Page 10 of 11

Student Number: 7640044 Date: 18 April 2011

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 The IRR is 18%.

 The profitability Index is greater than 1.

Further from the above financial assessment, the project of getting the new

machine means adapting new technology, a better quality product possibility

to yield higher revenue and company brand, greater flexibility for possibility in

better product differentiation and shorter production runs. All this benefits is

yet to be quantified that would result more saving for the company.

However, there has been an important thought that has not been take into

consideration is the amount of sales revenue could have been generated if old

machine and new machines were to operate at the same time.

Although there will be additional operational expenses occur for operating 2

machines at the same time, the turn key would be if both machines could

provide a higher profits, the decision of keeping the old machine thus will

change. However, some subjective issues would raise e.g. product having

different quality for running in 2 different machines thus could risk the

company brand.

References: -

1. Bob Ryan, (2008). Finance and Accounting For Business. 2nd Edition,

South-Western Cengage Learning.

2. Ciaran Walsh, (2008). Key Management Ratios. 4th Edition, Prentice Hall

Financial Times.

3. Brealey R., Myers S. and Allen F., (2008). Principles of Corporate

Assessment Reference: CF/Jan11/1

Name: Leong Khai Heng, Vivian Page 11 of 11

Student Number: 7640044 Date: 18 April 2011

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Finance. 9th Editions, McGraw-Hill.

4. Investopedia ULC, (2011). Financial Terms. Available at URL:

http://www.investopedia.com [Accessed 5th April 2011]

5. Wikimedia Foundation, Inc., (2011). Wikipedia The Free Encyclopedia –

Milling Machine. Available at URL: http://en.wikipedia.org/wiki/Milling_machine

[Accessed 5th April 2011]