Analyze The Viability Of A New Business Venture And Explore ✓ Solved

Analyze the viability of a new business venture and explore international

This Problem Set is based on materials covered in modules 5, 6, and 7. It is designed for you to demonstrate your understanding and be able to apply basic capital budgeting concepts, working capital management, dividend policy, and international financial management.

Sample Paper For Above instruction

Part 1: Capital Budgeting Analysis

Adams, Incorporated aims to expand into manufacturing and distributing animal feeds, involving a significant capital investment. The analysis begins by assessing whether certain prior costs should be included in project evaluation. Specifically, the $40,000 spent last year on upkeep of the empty lot is a sunk cost and should not influence current investment decisions, as sunk costs are unrecoverable and irrelevant to future cash flows (Brealey, Myers, & Allen, 2020).

Next, determining the machinery’s depreciable basis involves summing its purchase price, shipping, and installation costs. The machinery’s initial cost is:

  • Invoice price: $200,000
  • Shipping: $10,000
  • Installation: $30,000

Thus, the depreciable basis equals $200,000 + $10,000 + $30,000 = $240,000.

Using MACRS 3-year property depreciation rules, the asset is depreciated over 4 years with specific depreciation percentages applicable each year (IRS, 2023). The approximate annual depreciation expenses are calculated based on standard MACRS tables, resulting in the following approximate depreciation rates: Year 1: 33.33%, Year 2: 44.45%, Year 3: 14.81%, Year 4: 7.41%. Applying these to the basis yields annual depreciation expenses of approximately $80,000 for Year 1, $106,680 for Year 2, $35,440 for Year 3, and $17,680 for Year 4.

Annual sales revenue begins with the first-year sales of 1,250 units at $200 per unit, totaling $250,000. Given inflation at 3% annually, both sales price and costs increase accordingly each year. The cost per unit is initially $100, and total costs are computed as 1,250 units multiplied by the unit cost for each year, adjusting for inflation.

The incremental operating cash flows are assessed by calculating revenues, subtracting costs (excluding depreciation), accounting for taxes at 40%, and adjusting for depreciation. Additionally, net working capital (NWC) must increase by 12% of sales revenue each year, representing additional capital tied to sales growth, and is recovered at the end of Year 4.

The salvage value of machinery after four years is expected to be $25,000, which is taxable. The after-tax salvage cash flow considers the tax impact on the salvage amount, based on the machinery’s book value at that time and applicable tax rates (Berk, DeMarzo, & Harford, 2022).

Net cash flows are the sum of operating cash flows, changes in net working capital, and after-tax salvage value. These flows are used to compute key investment criteria: Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), and payback period. An NPV greater than zero, an IRR exceeding the WACC (10%), and a PI above 1.0 suggest project acceptability (Damodaran, 2015).

The payback period, while simple, does not consider cash flows beyond initial recovery and ignores the time value of money, making it less reliable for decision-making (Brealey, Myers, & Allen, 2020). Therefore, reliance solely on payback is discouraged, though it can provide supplementary information.

Interpretation of NPV, IRR, and PI indicates the project's potential profitability and risk. If all criteria are favorable, the venture should be undertaken. Conversely, negative NPV or an IRR below the threshold would suggest rejection.

Part 2: Working Capital Management

Adams Stores, Inc.’s cash conversion cycle (CCC) reflects the time between cash outflows for inventory and cash inflows from sales. It is calculated using inventory turnover, days sales outstanding (DSO), and payable deferral period. Currently, inventory turnover is 7.5, DSO is 36.5 days, and accounts payable deferral is 40 days, resulting in a CCC of:

  • Average inventory days = 365 / 7.5 ≈ 48.67 days
  • CCC = (Inventory days + DSO) - Payables days ≈ 48.67 + 36.5 - 40 = 45.17 days

Asset turnover ratio is Sales / Total assets: $150,000 / $35,000 ≈ 4.29. Return on assets (ROA) is Net profit / Total assets: (6% of $150,000) / $35,000 ≈ 0.086, or 8.6% (Ross, Westerfield, & Jordan, 2020).

Increasing inventory turnover to 9 times reduces inventory days to approximately 40.56 days (365/9). The new CCC becomes 40.56 + 36.5 - 40 ≈ 36.06 days, indicating quicker cash conversion. Asset turnover improves to $150,000 / (average inventory value at new turnover), and ROA increases proportionally, enhancing liquidity and profitability.

For the second scenario, reducing inventory turnover from 2 to 5 times while maintaining sales levels implies a reduction in inventory level, freeing up cash. Specifically, inventory levels decrease from (Sales / 2) to (Sales / 5). The cash freed equals the difference in inventory levels multiplied by cost per unit, resulting in substantial cash savings, which can be reinvested or used for debt reduction (Deloof, 2003).

Part 3: Dividend Policy

Dividend policy theories include:

  • Dividend Irrelevance Theory: Proposed by Modigliani and Miller (1961), suggests dividend policy does not affect a firm’s value because investors can create their own dividends by selling shares if needed.
  • Bird-in-the-Hand Theory: This theory asserts that investors value certain dividends more than potential capital gains due to risk aversion, implying higher dividends increase firm value.
  • Tax Preference Theory: Indicates dividends are less favored because they are taxed more heavily than capital gains, leading firms to retain earnings to maximize shareholder wealth (Litzenberger & Ramaswamy, 1979).

Management actions should consider these theories carefully. While the irrelevance theory supports flexible dividend policies, the bird-in-the-hand favors regular dividends, and the tax preference suggests retaining earnings to minimize dividend taxes.

Stock repurchases involve a company buying back its own shares. Advantages include increasing earnings per share, providing liquidity to shareholders, and signaling confidence. Disadvantages include potential market perception issues and reduced cash reserves (Jagannathan & Stephens, 2003).

Stock dividends and splits involve issuing additional shares to shareholders, effectively increasing the number of shares outstanding without changing the company's market capitalization. They can improve liquidity and signal confidence but may also dilute earnings, affecting per-share metrics.

Part 4: International Financial Management

A multinational corporation (MNC) operates across multiple countries. Firms expand internationally for reasons such as market diversification, access to cheaper resources, and strategic positioning (Shapiro, 2020).

Major differences in multinational finance include currency exchange risk, political risk, differing tax regimes, and managing cross-border cash flows. Exchange rate risk arises due to fluctuations in currency values, impacting profitability and cash flows (Eun & Resnick, 2014).

The current International Monetary System (IMS) has evolved from the Bretton Woods system (post-World War II fixed exchange rates) to a system of floating exchange rates since August 1971, when the U.S. abandoned the gold standard.

Spot rates are current exchange rates for immediate delivery, whereas forward rates are agreed-upon rates for transactions at a future date). The forward rate is at a premium when it exceeds the current spot rate, indicating expected currency depreciation, and at a discount when it is below, suggesting appreciation (Froot, 2020).

For Citrus, Inc., understanding these systems helps manage currency exposure, hedge risk, and plan international transactions effectively, ensuring profitability and financial stability during their European expansion.

References

  • Berk, J., DeMarzo, P., & Harford, J. (2022). Fundamentals of Corporate Finance.
  • Brealey, R., Myers, S., & Allen, F. (2020). Principles of Corporate Finance.
  • Damodaran, A. (2015). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset.
  • Eun, C. S., & Resnick, B. G. (2014). International Financial Management.
  • Froot, K. (2020). Exchange Rate Risk and Global Portfolio Investment. Journal of International Money and Finance.
  • IRS. (2023). MACRS Depreciation Tables. Internal Revenue Service.
  • Jagannathan, M., & Stephens, L. (2003). Incentive Effects of Private Placements of Shares. Journal of Financial Economics.
  • Litzenberger, R., & Ramaswamy, K. (1979). The Effect of Personal Taxes and Dividends on Capital Asset Prices: Theory and Empirical Evidence. Journal of Financial Economics.
  • Modigliani, F., & Miller, M. H. (1961). Dividend Policy, Growth, and the Valuation of Shares. The Journal of Business.
  • Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2020). Corporate Finance.

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