FIN20014: Financial Management - TOPONE Inc. Case Study Report Writing Assessment Answer

The Capital Budgeting criteria selected for analysis reject the decision to accept the project using the discounted rate of 14% being the WACC to the company. Based on the NPV, IRR and PI and Payback criteria, it is recommended that the Company should not go ahead with the project. If the decision to go ahead with the project is taken; the investment will cause a loss to the company and may not be able to generate profits and cash inflows for the company. The company might want to review its WACC of 14% as the project has the possibility of being accepted at slightly lower costs of capital.

Introduction

The objective of the report is to analyse and explain to the CFO of Top one Inc.; a manufacturer of Energy drinks for Athletes; the quantitative and qualitative issues involved in the introduction of their new experimental product. X-TRM. Capital Budgeting techniques have been used to evaluate the decision. The techniques of Net present value (NPV) analysis, Profitability index (PI), Internal rate of return (IRR), and Discounted payback period (PB) have been used to evaluate the financial viability of the decision. The analysis is based on the incremental discounted cash flow table discounted at the weighted average cost of capital to the company. This will aid the CFO to take the final decision about the continuance of the project.

Findings and Discussion

Analysis of Incremental cash flow associated with the decision

Graph 1

The yearly incremental cash flow table duly incorporating the tax effect of the incremental costs and revenue is annexed in Appendicle 1 and 2 and Graph 1 above. The table demonstrates the computation of the initial cash outflows and working capital for the first year as well as the incremental cash outflows for the six years of operation of the decision. The residual value inflow of the new P&E and working capital inflow at the end of the working life of the project have duly been considered for the capital budgeting analysis.

Incremental cash flows imply cash flows specifically associated with the decision. By implication, cash flows which are sunk costs and have already been incurred as well as irrelevant cash outflows are ignored. Specifically,

a) The Sunk cost of $150,000 for EDA research and $60,000 paid to experts for the prediction of cash flows for X-TRM have been ignored for the purpose of analysis as these have already been incurred and are irrelevant for the decision at hand.

b) The Working capital investment and HR procurement costs have been considered for the analysis as it is directly related to the project and are treated as part of the initial cash outflows associated with the project.

c) Annual Operating variable and fixed costs, TQM costs, tax savings on depricitaion and EDA research costs have been considered as these are directly related to the project.

d) The residual value of the new P&E has been considered at the end of the life of the project.

e) The Annual loss of revenue from production line of $ 36,000 is a relevant opportunity cost of implementing the decision and is considered as part of the annual cash outflows. The Company would have earned this revenue if the X-TRM project was not considered.

f) The net increase in revenue from brand cap sales of $ 12,000 is also an incremental inflow associated with the decision.

f) The cash flows are discounted at the Weighted Average Cost of Capital (WACC) of 14% so that the project is accepted only if the cash flows exceed the cost of capital to the company. All the cash flows were assumed to be incurred at the end of the respective years for the purpose of ease of analysis.

Findings on NPV, IRR and PI and Payback period criteria

The Capital Budgeting decision in relation to the project is analysed as follows

• The Profitability Index helps to compare the payoff of the project with the initial investment. Where the PI exceeds 1, the project present value exceeds the initial investment. (Investopedia, 2004)
• However, the computed PI of the project is 0.90 implying that the present value of the project is less than the initial investment. The criteria reject the decision to go ahead with the project to avoid future cash loss to the company.
• The NPV value of $ (396,976.48) also implies that the present value of cash inflows from the project are less than the initial outflow from the project and therefore does not recommend to go ahead with the project. Net Present Value (NPV) being the difference between the present value of cash inflows and outflows clearly points out the loss due to the decision duly incorporating the time value of money. The Criteria is based on the premises that cash received in the future is always worth less than the same cash received in the present as the opportunity cost of Cash could be invested somewhere else at better rates. (Kurt 2003)
• The IRR or the internal rate of return which theoretically equates the net present value of incremental cash flows to zero is 9.79 % which is less than the WACC or hurdle rate of 14% for the company. This implies that the project if undertaken would mean increased cash losses for the company.
• The Discounted payback period of 6.94 years is more than the required discounted payback period of 4.5 years which also justifies the rejection of the project.
• Appendicle 3 and 4 details the calculations where discounted cash flows @ 14% WACC have been used; duly incorporating the time value of money for taking an appropriate decision on the viability of the project.

Qualitative considerations and exposure to risks

• Energy drink business is normally considered as a high-margin business and is prone to issues like market saturation, existence of high brand competitors and increasing awareness of the customers to the ingredients, calories and health hazards. The research undertaken so far ought to have incorporated these factors. The possibility of health hazards and side effect to aged customers may jeopardize the existing image of the business. Therefore, serious thought needs to be given before going ahead with the decision.
• Due to high cost of Entry and huge investment, it is important to have a differentiated and exclusive product clubbed with a loyal customer base so as to override the competitors. This will also ensure increasing sales and sales volume.
• The low pricing of the Energy drink may lead to saturation easily in the long run due to better and low priced brands available in the market. This issue coupled with the risk of a low shelf life and a highly elastic demand makes the project unattractive overall. (Forbes.com, 2016)
• The company might want to review its WACC of 14% as the project has the possibility of being accepted at slightly lower costs of capital.

Conclusion and Recommendation

The Capital Budgeting criteria selected for analysis reject the decision to accept the project using the discounted rate of 14% being the WACC to the company. Based on the NPV, IRR and PI and Payback criteria, it is recommended that the Company should not go ahead with the project. If the decision to go ahead with the project is taken; the investment will cause a loss to the company and may not be able to generate profits and cash inflows for the company. The company might want to review its WACC of 14% as the project has the possibility of being accepted at slightly lower costs of capital.

Annexure

Appendicle 1 Annual Incremental Cash flow table with working

Working for Tax savings on depreciation

Appendicle 2 Annual Incremental Cash flow table

Appendicle 3 Capital Budgeting calculations

Appendicle 4 Capital Budgeting calculations