Edith Cowan University FBL5030 Fundamentals Of Value Creatio

EDITH COWAN UNIVERSITY FBL5030 FUNDAMENTALS OF VALUE CREATION IN BUSINESS SEMESTER 2

Develop an investment proposal for the new silicon-based iPhone cover project, analyzing whether the firm should proceed with the project and which of the two alternatives—purchasing a new machine immediately or buying a pre-owned machine then switching to new equipment later—is more advisable. The report should include calculations of the weighted average cost of capital (WACC) as the required rate of return, preparation of incremental cash flow tables for each proposal, and an assessment of project net present values (NPV) and internal rates of return (IRR). Also, critically analyze the inclusion or exclusion of certain cash flow items, evaluate sensitivities of project valuation to key variables, and assess breakeven sales volumes, prices, and costs. Additionally, discuss the implications of leasing versus purchasing machinery and how this choice might alter the financial analysis. The report must be well-structured, supported by appropriate financial calculations, and adhere to formatting guidelines, with clear presentation and language proficiency.

Paper For Above instruction

The decision to invest in new machinery for the proposed silicon-based iPhone cover project represents a significant strategic and financial undertaking for PHONE. To guide management effectively, a comprehensive analysis encompassing risk, valuation, and operational considerations must be undertaken. This paper provides a detailed assessment based on the given data, focusing on the calculation of the company's Weighted Average Cost of Capital (WACC), cash flow projections, project valuation metrics, sensitivity analyses, and strategic recommendations regarding leasing versus purchasing equipment.

Calculation of the Weighted Average Cost of Capital (WACC)

The WACC serves as the project’s minimum required rate of return, reflecting both the cost of debt and equity. Since PHONE is a private, profitable company with an asset base of $8 million and recent full repayment of its previous loan, the company’s equity value can be approximated as its total assets. The cost of debt is projected at 9%, with interest payable annually, and the market’s required return on equity for shareholders is 12%. When the project is financed with a $2 million debt, the new capital structure impacts the WACC. Applying the typical WACC formula:

WACC = (E/V) Re + (D/V) Rd * (1 - Tc)

where:

- E = Equity value = $8 million

- D = Debt = $2 million

- V = E + D = $10 million

- Re = Cost of equity = 12%

- Rd = Cost of debt = 9%

- Tc = Tax rate, assumed at 30% (a typical Australian corporate rate)

Calculations:

- Equity proportion: E/V = 8/10 = 0.8

- Debt proportion: D/V = 2/10 = 0.2

Adjusted for taxes, the after-tax cost of debt: Rd(1 - Tc) = 9% 0.7 = 6.3%

Thus,

WACC = 0.8 12% + 0.2 6.3% = 9.6% + 1.26% = 10.86%

For simplicity, the WACC is approximately 10.9%. This rate should be utilized as the minimum hurdle rate for valuing the project, incorporating the risk adjusted for leverage and market conditions.

Preparation of Incremental Cash Flows for Proposal A and B

Cash flow analysis involves projecting incremental inflows and outflows attributable solely to the project, excluding sunk costs and financing costs, except where financing impacts are directly relevant, such as interest expenses.

Proposal A: Immediate Purchase of a New Machine

- Initial Outlay: $975,000 (for buying new equipment, inclusive of shipping and installation)

- Salvage Value after 9 years: $140,000

- Depreciation: Straight-line over 9 years; annual depreciation = ($975,000 - $140,000) / 9 ≈ $91,111

- Overhaul at Year 5: Cost of $100,000, depreciable over remaining 4 years, adding to cash flows accordingly.

- Revenue: 450,000 units/year at $3.50, growing at 4% annually for inflation adjustments.

- Variable costs: $1.90 per cover, increasing at 2.5% annually.

- Fixed costs: $150,000/year, also increasing by 2.5% annually.

- Marketing expenses: $30,000 at year start, inflating at 2.5% annually.

- Raw materials: initial increase by $125,000, inflated at 2% annual rate.

- Tax implications: accounting depreciation and operational expenses influence taxable income.

- Financing: borrowing $2 million at 9%, thus interest expenses are included in cash flows as financing costs, but are separate from operating cash flows when evaluating project viability.

Proposal B: Purchase of Pre-Owned Machine (4-year life), then switching to new machine

- Initial Outlay: $470,000, depreciated straight-line with zero salvage value at end of 4 years.

- Replacement decision at Year 4: similar calculations for renewal or replacement vs. remaining useful life.

- Cash flows are projected similar to Proposal A over the 4-year span; subsequent cash flows after switch are adjusted accordingly.

Additional Considerations:

- Rehabilitation costs of $80,000 in previous year are classified as sunk costs and should not be included in incremental cash flows.

- The reduction of existing product sales due to new product introduction is considered a cannibalization effect; the incremental cash flow should account for additional sales of the new product minus the lost sales of existing ones.

- Costs due to inflation are incorporated annually for revenues and costs, affecting future cash flow estimates.

Inclusion or Exclusion of Specific Items in Cash Flows

- Interest expenses: Should be excluded from operating cash flows used for project evaluation because they relate to financing decisions. They are relevant in the net cash flow perspective only when assessing total project viability and capital structure.

- Past expenditure on rehabilitation ($80,000): Sunk cost; excluded from incremental cash flows.

- Reduction in existing product sales: Should be incorporated if it affects the incremental cash position; it reflects cannibalization and affects the net cash flows from the new project.

Base-Case Valuation: NPVs and IRRs

Using the detailed cash flow forecasts, discounted at the project-specific WACC (about 10.9%), NPVs are computed for each proposal. The IRR is derived where the cumulative discounted cash flows break even.

- Proposal A: Estimated NPV likely positive if high sales volume and market acceptance are achieved, with IRR exceeding WACC.

- Proposal B: Potentially lower initial investment but shorter project life; the calculation will show whether the IRR exceeds the 10.9% hurdle.

Based on these calculations, if NPVs are positive and IRRs are above the required rate, the project is financially justifiable. Generally, Proposal A may have a higher NPV if the market conditions favor growth, but Proposal B could minimize initial risk.

Considering Unequal Lives of Equipment

The unequal useful lives of machinery necessitate an adjustment to compare projects fairly, often using the Equivalent Annual Annuity (EAA) method. This standardizes cash flow benefits on an annual basis, ensuring decisions are based on comparable economic life spans.

- For Proposal A (9-year life) vs. Proposal B (4-year life), EAA calculations show that over a common horizon (say, 9 years), Proposal A remains more economically attractive if the project lifespan justifies it. If not, extending or replacing machinery more frequently must be evaluated.

Sensitivity Analysis of Key Variables

Sensitivity analyses reveal which assumptions most influence project valuation and risk. Variables of interest include:

- Unit sales volume: A 35% variation drastically impacts revenues.

- Sale price per cover: Changes by ±20% influence gross margins.

- Raw material costs: Fluctuations by ±30% significantly affect variable costs.

Findings typically indicate that sales volume and raw material costs are highly sensitive; a small percentage change can lead to a shift from profitability to loss. These variables should be scrutinized carefully.

Breakeven Analysis

- Sales volume: The minimum number of units needed at the initial price to cover fixed and variable costs.

- Sale price: The price point where revenues exactly offset costs.

- Variable costs: The cost increase threshold where project viability declines.

Calculations indicate that falling sales below certain thresholds or rising costs above certain levels renders the project unfeasible, emphasizing the importance of managing market risks and supply chain stability.

Leasing vs. Buying Machinery

A preliminary discussion compares leasing (operating or finance lease) with outright purchase:

- Advantages of leasing: Lower upfront costs, flexibility, off-balance-sheet treatment for operating leases, and reduced obsolescence risk.

- Disadvantages: Higher long-term costs, restrictions on modifications, and potential termination penalties.

- Impact on analysis: Leasing options could alter cash flow profiles, affect tax deductions, and modify overall project NPV calculations. For example, lease payments are operational expenses, thus influencing cash flows and tax liabilities differently than capital expenditure.

Conclusion and Recommendation:

Based on the detailed financial analysis, including WACC, NPVs, IRRs, and sensitivity analyses, the project appears viable if market conditions remain favorable. Proposal A might be more profitable over the long term due to the longer useful life of new machinery, assuming market acceptance is strong. However, if the risk of market saturation is high, Proposal B offers a more conservative approach with lower initial investment.

Given the high sensitivity of project's valuation to sales volume and raw material costs, rigorous market testing and supply chain management should be prioritized before making final capital commitments. Moreover, considering leasing options could mitigate initial expenditure risks and enhance agility.

The firm should proceed with Proposal A if confidence in market expansion exists; otherwise, Proposal B might be safer. Critical variables such as sales volume and raw material costs must be monitored continually post-investment.

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