Engineering Products PLC

6 Pages   |   2,410 Words

Introduction

The steel tube division of Engineering Products is considering the purchase of a new milling machine. The company has traditional employed methods of investment appraisal such as payback period. The new project does not satisfy the payback criteria for project appraisal. However, it is often argued that the discounted cash flow approach a more thorough evaluation of the value added by a project. There are additional concerns about the calculations of profit projections, which are predominantly negative. Moreover, the project also involves additional cash flow considerations that include marketing expenses and loss of sales of other products. It is important to consider only the cash flows that are relevant to the undertaking of the project, and exclude the irrelevant cash flows. The following sections discuss the merits of a discounted cash flow approach, and provide a recommendation after considering all the relevant project cash flows.

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The Discounted Cash Flow Approach

The discounted cash flow approach has gained popular approval with the passage of time. The basic concept behind the discounted cash flow approach is that projects should be judged based on the value added by them. Traditional measures like payback period fail to account for all the characteristics of the cash flows related to the project. There are two main drawbacks of using just the payback period for investment appraisal. First, the payback period does not account for the time value of money. For instance, consider two projects that return the initial investment of $100 in two years’ time. However, project A generates $80 in the first year and $20 in the second, while project B generates all of the $100 dollars in the second year. Assuming that everything else is the same about the two projects, investors would clearly prefer the first project because it generates higher cash flows in the first year. However, the payback period does not tell us anything about the timing of the cash flows. Similarly, payback does not tell us anything about the cash flows that are due to be realized after the initial investment has been recovered. For instance, consider the same example of project A and B discussed earlier. Project A delivers a further cash flow of $50 in the third and fourth year, but project B only deliver $20 in the next two years. Considering this information, the investors would definitely lean towards project A because it provides a higher total cash flows. Once again, payback period fails to account for the total cash flows related to the project.

The return on investment metric used by the company does account for the total cash flows associated with projects. However, the return on investment does not take the time value of money into account. The discounted cash flows (DCF) approach is argued to be a superior method on investment appraisal because it accounts for both the amount and the timing of all the cash flows. The discounted cash flows are calculated in accordance with the risks associated with each project. The discount rate, which is used to discount the cash flows, is calculated in accordance with the risk associated with the cash flows. Therefore, DCF approach gives us the risk adjusted cash flows associated with the project. If the sum of the discounted cash flows, called the net present value (NPV), of a project is positive, the project is said to be adding value to the company. In other words, a positive NPV project is said to increase the wealth of the owners of the company by providing them with positive risk-adjusted returns.  The main aim of every business entity is to maximize the wealth of its owners. Therefore, a company should only accept a project if it provides a positive NPV, as measured by the discounted cash flow (DCF) approach.

Relevant Cash Flows

Since projects are implemented in a going-concern company, some required costs of a project are not actually incurred. For instance, the Engineering Products might not need to hire any additional administrative staff for the new project. Therefore, the company will continue to incur the same administrative expenditure regardless of whether the project in undertaken or not. It is important to include only the relevant cash flows associated with the project. The relevant cash flows are usually defined as the incremental cash flows that are dependent on the decision to undertake the project. If a certain cash flow is not affected by the existence of the project, it should not be included in the calculation of the project. In the case of the company’s administrative expenditure, an argument could be made that a portion of the administrative staff would be working on the new facility and that cost should be appropriated to the project. However, the salaries are not expected change if the project is undertaken. Based on the assumption that the decision to undertake the project has no effect on the salaries of administrative staff, it could be argued that the administrative expenses are not incremental costs associated with the project, and they can be ignored. Similarly, the allocation of fixed overheads (20% of labor costs) is not incremental to the project. The company will still incur these overheads if the project is not undertaken, and they should be excluded from the profitability analysis of the project.

Another important concept that is closely related to relevant costs is the concept of sunk costs. Sunk costs are the costs that may be associated with the project, but have already been incurred and cannot be reversed if the project is not accepted. Such costs do not depend on whether the project in undertaken or not. Therefore, these costs are not incremental to the decision and should not be considered in the calculation of the project. In the case of engineering, the $18,000 paid to marketing consultants has already been incurred and cannot be recovered if the project is abandoned. Therefore, the consultancy fee is a sunk cost that should be ignored in the calculation of relevant cash flows. On the other hand, the projected is also expected to create certain costs that are not accounted in the profitability analysis. The most obvious cost is the additional marketing expenditure that will need to be incurred in order to achieve the forecasted sales. A more subtle cost of the project is the cannibalization of the sales of existing products of the company. It is expected that the projected be expected to cannibalize sales worth $60,000 each year. The loss of cash inflows from the cannibalized cash flows is another relevant cash flow that has to be considered in the calculations. It is also important to adjust the profits for non-cash considerations such as depreciation that do not result in an actual outflow of cash. The calculation methodology of the relevant cash flows is presented in the following section.

Project Appraisal

The profit projections of the accountant contain certain irrelevant cash flows such as administrative expenses and allocation of production overheads. These cash flows have to be removed when calculating the ‘adjusted profits’ of the new project. The calculation of adjusted profits is detailed in the attached spreadsheet (see working 1). The profits have been calculated assuming a straight-line depreciation. For the purposes of project appraisal, depreciation is a non-cash expense and is only relevant with regards to the tax-shield that it provides. The tax authorities permit the use of a 25% reducing balance depreciation on the new milling machine. Therefore, the adjusted profits have been recalculated assuming a 25% reducing balance depreciation. Note that this may not be the actual accounting treatment of the depreciation, but it gives a better estimate of the actual taxes that the company will have to pay on the profits from the new machine. Note that the adjusted profits are only negative in the first year. After the first year, the profits turn positive, which increases the chances of realizing a positive return on the investment. The taxes are deducted on the adjusted profits to obtain the after-tax profits that will be realized on the investment.

These profits include certain amounts that need to be excluded to obtain the relevant cash flows related to the project. Depreciation is a non-cash charge that does not lead to an actual outflow of resources. Therefore, depreciation does not directly affect the cash flows from the project. An indirect impact can be postulated in the form of tax shield provided by the depreciation. The tax shield from depreciation has already been included in the calculation of adjusted profits. Therefore, the depreciation expense should be added back to the after-tax profits in order to get a estimate of the cash flow related to the project. Similarly, the interest expense, deducted from the profits, should be added back to the after-tax profits. Interest expense is the cost of the funds use to finance the project. The affect of the cost of funds is usually measured in the discount rate used to calculate the present value of project cash flows. The discount rate will be discussed in more detail in a later discussion. After the adjustments of depreciation and interest rates, the profits will portray cash flows that are more closely associated with the project.

The accountant has also ignored some other cash flows that are relevant to the project. These cash flows include the marketing expenditure, cost savings, and the cannibalized cash flows of the old products. These cash flows are calculated on an after-tax basis because the cost savings are likely to be taxable while the marketing costs are likely to be tax deductible. The loss of cash flows from the cannibalized sales is estimated by adjusting the gross profits for the taxes payable on the net profits. The assumption behind this estimation is that the indirect (non-operating) costs related to the cannibalized sales are fixed, and will continue to be incurred even after the decrease in sales. Adjusting these cash flows will give us the net cash flows that are expected to be generated by the machine in its four years of operations.

The initial cash flow for the project is comprised of the purchase price of the machine, the after-tax proceeds from the old machine, and the purchase of opening stock. The company can also realize additional proceeds by selling the new machine at the end of four years. The book value, based on the reducing balance method of depreciation, is expected to be higher than the sale price. Therefore, the company will also earn a tax credit on the sale that is added to the proceeds from the sale of the machine. By choosing to sell the machine now, the company is also giving up the opportunity to sell it at the end of four year. Therefore, the opportunity cost of the sale of old machinery is added to the year 4 cash flow. Adding all the related cash flows from the project gives us the net incremental cash flows related to the project. It is important to note that the cash flow is positive in all of the later years of the project. This is in sharp contrast to the accountant’s profitability forecast, which was predominantly negative. The relevant cash flows can be discounted at the discount rate of 10% to get a positive NPV. It is not clear if the 10% discount rate is an appropriate measure of the risk associated with the project. If the project is believed to have the same risk as the company’s usual operations, the company should discount the cash flows at the company’s weighted average cost of capital (WACC). In this case, the WACC cannot be calculated because of the lack of sufficient information.

Strategic Considerations

The new machine also holds some strategic importance from the company. Apart from the short-term benefits, the new technology associated with the machine may enable the company to improve its product quality. The improved product quality might attract more sales in the future. It might also allow the company to maintain stable customer base and raise its future prices without losing significant sales.  Moreover, the improved technology will give the company more flexibility and increased efficiency through shorter production runs. Such attributes can be advantageous in the long-term, as it will give the company a competitive advantage over its contemporaries. Therefore, the total benefits associated with the project may be more than the benefits reflected in the cash flows. Some of these strategic benefits can be hard to quantify. Therefore, the company might be forced to consider these benefits based on their qualitative characteristics. The strategic benefits might compel companies to consider borderline projects that may not fully pass the required investment hurdle rates, but promise significant strategic advantages.

Recommendation

Even from the perspective of observable cash flows calculated in the attached spreadsheet, the project appears to be favorable. The project has a positive NPV of over $33,000 if the cash flows are discounted at the stated cost of capital of 10%. However, the 10% cost of capital has no economic basis. The finance director at the head office did not specify any hurdle rate they might use to evaluate the project. However, 10% might prove to be low, as the division has recently realized a return of 16% on assets. Ideally, the discount rate should reflect the risk associated with the project. The project has an IRR of 14.3%. If the company believes the appropriate discount rate, which reflects the risk of the project is less than (or equal to) 14%, the project should be accepted.

However, the decision is further complicated by the fact that the company has a shortage of funds. Therefore, the company should only accept projects that add the maximum value, while accounting for the initial required investment. The profitability index measures the ratio of the present value of project’s cash flows to the required initial investment. Under an unrestricted capital budget, a company should accept projects with a profitability index greater than one, as it indicates positive NPV projects. Under a restrictive capital budget, a company can only accept the projects with maximum profitability index. For the milling machine, the profitability index is 1.11. Therefore, the company should accept the projects with profitability indexes higher than 1.11 before accepting the milling machine project. However, the strategic importance of the project might constitute a compelling reason to prefer this project to other projects, especially if the project satisfies the hurdle rate required by the head office.

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