Introduction
Decisions on new investments entails considering various aspects of a project. In that respect, the cost and return aspects of a project are key to an investor and there are various methods of analyzing the value expected from such projects. With that, capital appraisal is a crucial process for businesses and investors and this report presents an analysis of the Deluxe case that considers introducing a new range of clothes to address the market changes. Capital budget appraisal, referred to also capital budgeting primarily is a process facilitating firm’s investments determination concerns for both long-run and short-run. It also refers to the procedure of analyzing as well as ranking the proposed projects in determining which deserves investment funding. The end result is anticipated to be substantial returns on the invested funds. With that, the report provides an overview of the appraisal methods applied arriving at a final decision on the project’s feasibility.
Analysis
The appraisal entails considering the various aspects of the project that range from its costs, returns, taxation and the appraisal methods used. In that respect, the following is a summary of the various aspects of the Deluxe case appraisal with the necessary calculations decisions. Some of the aspects covered include the projects, fixed cost, the applied discounting of the expected cash-flows, depreciation, taxation and the NPV as well as the IRR techniques applied in the appraisal.
Fixed cost
The fixed cost refers to cost which does not vary with rise or fall in the quantity of commodities or services that are produced. These are the expenses that must to be compensated by a firm, independent of business activity. This is among the two elements of the entire cost for a product or even service, alongside the variable cost.
In view of the Deluxe case project, the fixed cost is considered as the depreciation of the project that is constant over the period regardless of the level of sales and operations.
Cash flow discounting analysis
Any given capital investment includes an initial outflow of cash to make payment for it, then followed by mix of inflows of cash in form of the revenues, or decline in the present cash flows which result from expense reductions. The information can be laid down in spreadsheets showing all anticipated cash flows during the useful time of the investment. Then one can apply a suitable discount rate which reduces the cash flows up to what it should be worth currently. The calculation is referred as NPV. The NPV, usually a traditional way for evaluating the capital proposals, as it is on basis of a one factor; cash flows can help judge any given proposal emanating from anywhere within a company. In that respect, the cash-flows for the Deluxe project are discounted at the company’s desired rate that reflects its risk appetite.
Capital’s cost
Capital’s cost simply is the return estimated by the one`s providing capital for that business. In several businesses, cost of the capital is below the rate of discount or the needed return rate. For instance, a firm`s cost for capital could be 10 percent but the department of finance will pay that amount and use about 10.5 percent or even 11% as the discount. How much is paid for will determine appetite risk. A company that is risk-averse might increase the rate of discount even more, to about 15-20 percent. But if that business is focusing on stimulating investments, the investor might decrease their rate, even just for given time period (Gallo, 2015).
In view of the Deluxe case, the project has a Capital’s cost of 8% which is considered as the discounting rate in the analysis. However, given the perceived risk for the project, the business has increased Capital’s cost’s estimation to 9%.
Sensivity analysis
The sensitivity analysis refers to repeat of primary analysis or the meta-analysis that is substituting the alternative decisions or even ranges of the values of decisions that are unclear or arbitrary. The key goal for sensitivity analysis regards gaining insight into the assumptions that are significant in terms of which assumptions impacts the choice. This process involves many ways of changing the input values for the model to reflect the effect on output value. During some decision there may be use of one model in order to investigate many alternatives. However, in other cases, one may use different spreadsheet model for the various alternatives.
In view of the sensitive analysis, the Deluxe project of introducing a new range of clothes is analyzed considering three scenarios. The first scenario is the base scenario which represents what has been forecasted as the expected profits for the new project. However, as a means of addressing uncertainty, the project is analyzed in view of two other scenarios where the forecasted profits are assumed could vary by 5% for the worst scenario and 15% for the best scenario. With that, the Deluxe’s project has the NPV and IRR calculated for the three scenarios.
Depreciation
The straight line depreciation used in this case refers to default way used to slowly decrease the carrying quantity of fixed asset over its useful life. This method is well designed to show the consumption pattern for underlying asset and mainly used when no particular pattern is identifiable regarding how the asset requires to be utilized over time. Making use of straight-line technique is greatly recommended, because it`s easiest depreciation technique to calculate. Further, the method results in little calculation errors. Finally, the technique recognize the depreciation expense consistently over an estimated and useful life of the asset.
In view of the Deluxe’s project, the depreciation considers the residual value of the fixed assets that 10%. With that, depreciation has been calculated by deducting the residual value from the initial fixed cost and then dividing by the three years over which the project is being considered. In the analysis, the depreciation amount is added back to the profit after tax to provide the net cash-flows for the company.
Taxation
In view of the analysis, the business profits are taxed at 25% and the profit after tax provides the cash-flows to which the depreciation amount is added back.
With application of the discounted cash-flows method, the project’s feasibility is appraised as follows considering a sensitivity analysis over three scenarios.
With the profit before tax, the tax is deducted to get the profit after tax which represents the earnings that the business is free to expend. However, with depreciation item, it requires to be added back to provide the actual cash balance reflecting the earnings. Further, the analysis for the three scenarios is done in consideration that the project’s initial cost includes the fixed assets cost, the working capital cost and the consultation fee incurred in researching the market. With that, the initial noted capital of 46M has been broken down into 30 M for fixed assets cost and 16 M for the working capital. That would be useful in calculating the depreciation figure that should only consider the fixed assets cost. Further, the calculations considers that the working capital is presumed to carry the same initial value as at the end of the three years period hence its consideration in the residual value of the project that comprise the fixed assets scrap value and the working capital.
With the three scenarios considering a base performance, worst case of 5% more profit before tax than the forecasted base scenario and a best scenario of 15%, it is clear that the increase in the profits enhances the cash-flows hence the NPV values although they remain negative, In addition, the increase in the expected profits features an increase in the IRR being an indication that the more the profits, the better the cash-flows and the return expected from the project.
NPV
NPV refers to a technique that is used in determining the current value of investment by discounting the sum of all the cash flows that are received from that project. When an investor or a company takes on projects or investments, it is crucial for calculating an approximation of how much profit the investment or project will earn. Putting into considering that money flowing out is a minus from the discounted amount of the cash flows coming in; a project requires having a positive NPV figure to earn a consideration as a valuable investment (Damodaran, 2010).
In view of the Deluxe project, the NPV analysis is done considering the business Capital’s cost adjusted specific for the project. With that, a discount rate of 9 is used to discount the three years cash-flows. In addition, considering that the project has a residual value of 10% of the fixed assets value, the NPV considers its value at the end of the project in addition to the working capital that is considered as being equivalent to the initial amount. Finally, it is clear that the three scenarios would have negative values. In that respect, the project would be considered not feasible using the method.
IRR
IRR refers to interest rate where the NPV for all cash flows; both negative and positive from investment or project equal zero. The rate is for evaluating the suitability of any investment or project. When IRR for a project surpasses a firm`s needed return, the venture is suitable. However, if the IRR goes below the needed return, the venture is not desirable.
The general rule requires that IRR value is impossible to be analytically derived. Instead, the IRR ought to be found through the use of mathematical trial to obtain the rate that is appropriate. However, many business calculators as well as spreadsheet programs shall automatically perform the function as in this case.
Further, IRR allows the managers to level projects through their sum rates for return instead of their own net current values where the investment having the largest IRR is usually preferred. Also, its comparison ease do make IRR attractive, though there are limitations to its worth. For instance, IRR only works for investments which have initial cash outlay (purchase of investment) been followed by a single or even more inflows cash. Additionally, the IRR do not measure the actual size of investment or return. That means it could favor the investments with high return rates even if dollar amount for return is extremely small (Damodaran, 2010).
In view of the Deluxe’s project for the new range of clothes, the IRR values for the three scenarios are higher than the required return of 8% and are significantly high considering the higher returns per years regardless. In that respect, the IRR valuation considers the project viable over the three scenarios regardless of the negative NPV values. With that, it is an indication that the project could have been had suitable and significantly high NPV had it had a longer period than the three years in consideration.
Conclusion
In view of the analysis, it is clear that if the project is considered for only three years, the NPV would be negative and would not be feasible. However, the project has significantly high IRR compared to the company’s required rate of return of 8%. In that respect, the use of NPV only would be considered inadequate as the IRR indicate that a longer period project would be desirable. In conclusion, considering only the three years even with the three scenarios leaves the project unfeasible by NPV appraisal.
The analysis has also demonstrated the weaknesses of the IRR evaluation method where the project that has negative cash-flows features significantly high IRR rates. With that, the business should use combination of various appraisal methods including others such as the pay-back period that would define when the business expects its funds to be repaid back. That would act as a benchmark for which the other methods including the applied NPV and IRR would be used.
Thus, for the business, it would be better off not to introduce the new range of clothes with a view of a three years horizon as that would result in negative net present value cash-flows that would not be desirable for a business seeking to enhance its profitability and sustainability in the changing market. The undesirability of the project is also contributed by the high cost of capital applied considering the high risk that the business considers the project to be. However, a longer time horizon would provide more cash-flows to enhance the NPV.
References
Damodaran, A. (2010). Applied Corporate Finance. 3rd Ed. Colorado: Wiley.
Gallo, A. (2015). A Refresher on Capital’s cost. HBR April 30 2015, Retrieved 01 March 2016 from, https://hbr.org/2015/04/a-refresher-on-cost-of-capital
