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ACC00716 The Financial Analysis

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This assignment has a 25% weighting in your overall mark for this unit and focuses on content from Weeks 6, 7 and 8. The assignment will be marked out of 25 and marks will be allocated as indicated in the rubric below. Your total assignment submission will consist of a word document that should not exceed 1,000 words (excluding reference list), plus a spreadsheet submission. The assignment is based on the hypothetical case information below. Pinto Limited has recently been subject to significant competition from overseas manufacturers with much lower costs. To combat this, Pinto is considering a project that will see it move into a new product market considered riskier than its current operations. The CEO has asked you to undertake a financial analysis of the proposed project and present your recommendations in a short memo. As part of your financial analysis you will calculate NPV, IRR, payback period, discounted payback period and profitability index.

The project requires an upfront investment in plant and equipment of $15 million, which will be depreciated on a straight-line basis over the five-year life of the project. The equipment is not expected to have any significant salvage value at the end of its depreciable life. Pinto paid $25,000 in fees to consultants for a market analysis related to the project. This analysis predicted sales volume of 200,000 units in the first year, which would grow by 50% per year in years two and three, and fall by 50% in each remaining year as demand wanes. Selling price in the first year is expected to be $75 and grow by 3% each year after that. Pinto’s operations manager has estimated cost of goods sold for the project will equal 60% of sales revenues and selling, general and administrative expenses directly related to the project (excluding depreciation) will be $1 million in the first year and increase by 5% per year thereafter. The operations manager has not included in his estimates any cost for a project operations base because the plan is to use a building the company already owns.
Currently Pinto rents this building to another company for $250,000 per year. The project will require an upfront investment in net working capital equal to 20% of the year 1 sales revenue forecast. This investment in working capital will be fully recovered at the end year 5. The company has a 10% weighted average cost of capital and is subject to a 30% tax rate. Required: Prepare (1) a spreadsheet financial analysis of the proposed project and (2) a memo to Pinto’s CEO that briefly explains and justifies your chosen methods and any assumptions made, summarises your findings, and presents your recommendations on the proposed project.

Answer:

The company is currently facing high competition in the current business and thereby has decided to launch a new product which can potentially prove to be the future growth engine. However, considering that the new product launch has a higher risk profile in comparison to the current operation, the given memo aims to present the key findings in relation to the financial analysis of the proposed project. The analysis of the project not only considers the base case based on the current estimates but also has considers tools of uncertainty analysis to provide a glimpse of the financial feasibility in case of adverse movements in key input variables. Recommendations at the end of the memo have been offered based on the highlighted analysis that has been undertaken for the project. For estimation of the incremental cash flows, few vital points are highlighted below.

    • The production of the new product would be undertaken at the factory currently under the company’s ownership. But, the factory is currently being used by an outside party and thereby the company is able to earn $ 0.25 million as rental income every year. Therefore, it is significant to take note that the usage of the factory would not be free but would cause a decline in the rental income of the company by $ 0.25 million and therefore this is taken as the opportunity cost for factory usage (Petty et. al., 2015).
    • Considering that the product to be launched is new, hence the services of an external consultant were used for estimation of the potential sales and also revenue realisation. However, the emolument extended to the consultant does not feature in the incremental project related cash flows owing to this expense recognised as a sunk cost that cannot be altered now irrespective of the fate of the project (Northington, 2015).
    • Besides, it has also been assumed that all the cash flows arising on account of the project would be realised only at year end which is critical so that the time value of money concept can be introduced with relative ease (Damodaran, 2015).

Incremental Cash Flows

Considering the cash flows that has been estimated and also the given discount rate of 10% for the project, the computation of the following capital budgeting parameters has been facilitated in the supporting excel.

Based on the above computed values of the key capital budgeting parameters, under the base case, the conclusion can be drawn that on each of the criterion listed above, the given project is acceptable and reflects financial feasibility (Northington, 2015).

Uncertainty Analysis

Considering the project deals with a new product, it is necessary to take into consideration deviations from the base case. One of the unknown input variables is the growth rate of product sale which has been estimated by the consultant but can deviate and has to be considered. Also, considering the higher risk associated with the product, the discount rate also may show deviation on the higher side which ought to be considered.

  • Scenario Analysis

The above deviations need to be reflected through two scenarios namely an optimistic scenario and pessimistic scenario.

Optimistic Scenario (Associated probability = 25%)

The key underlying assumptions in this scenario are summarised below.

  • The product volume sales are more than expectations and thereby the sales growth estimate for year 2 and year 3 can be enhanced to 75%.
  • The incremental demand provides higher pricing leeway to the company which leads to annual product price hike of 4%.

Obtained NPV = $11.57 million

Pessimistic Scenario (Associated probability = 35%)

The key underlying assumptions in this scenario are summarised below.

  • The product volume sales are less than expectations and thereby the sales growth estimate for year 2 and year 3 can be reduced to 30%.
  • The lower demand provides does not pricing leeway to the company which leads to annual product price hike of 2%.

Obtained NPV = $1.44 million

Expected NPV = 0.25*11.57 + 0.4*5.6 + 0.35*1.44 = $ 5.636 million

  • Sensitivity Analysis

Recommendation

In accordance with the financial analysis summary presented, it would be appropriate to recommend the acceptance of the proposed project on the following counts (Petty et. al., 2015).

  • For the base case, the various applied capital budgeting tools result in project being accepted from financial feasibility perspective.
  • Considering the various scenarios and their respective likelihood, the expected NPV derived exceeds zero on the positive side implying that the project is financially feasible.
  • The project robustness and financial feasibility is also indicated in sensitivity analysis where only in very extreme cases would be project be loss making. 

References

Brealey, R. A., Myers, S. C., & Allen, F. (2014) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.

Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.

Northington, S. (2015) Finance, 4th ed. New York: Ferguson

Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications

Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French Forest Australia.


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