Table of Contents
1 Executive summary 3
2 Statement of problem 4
3 Analysis and methodology 5
3.1 The economic break even analysis 5
3.2 Project’s sensitivity to residual value 5
4 Discussion of results 8
4.1 The economic break even analysis 8
4.2 Project’s sensitivity to residual value 9
5 Conclusion 10
The following report discusses the viability of a capital investment project that Rediform Concrete is considering. Rediform Concrete, as can be inferred from the name, is a company that prides itself in the production of concrete. It would like to venture into production of formed concrete products such as patio stones, mobile home stones and lawn decorations.
Data used for the analysis is internal drawn from the company’s records regarding their equity beta, the market returns and risk free return. The aforementioned give a weighted average cost of capital of 10%. The company has also projected revenues and costs associated with the investment, annual after tax cash flows are 50% of sales while annual fixed costs amount to $500,000. Notably, the factory has a residual value contingent on land prices in the area which are also contingent on whether or not the new freeway exit for Sunshine Expressway is built on Palmetto Road, where fortunately, the factory is situated. The data has been analyzed by examining the sensitivity of the project to the salvage value as well as conducting a break even analysis.
From the break even analysis, it is seen that 6,000,000units of sales will have to be produced annually so as not to make losses. Thus to make profits, more than 6,000,000 units must be produced and sold. The shortcomings of the break even analysis include the fact that they only consider the supply side, discounting the fact that the demand for the products, which the company has no control over and which they can not accurately predict though they have their estimates, has a bigger role to play in the determination of whether or not the company makes profits or losses.
From the sensitivity analysis, it is clear that whichever way the subway exit is built, there will be a positive net present value from the company which would be a signal that the company runs with the plan. However, the internal rates of return for both circumstances tell a different tale – they are both lower than the weighted average cost of capital.
In conclusion, it would be wiser to place more weight on the sensitivity analysis given the major shortcoming of the break even analysis. Thus, given the abovementioned reasons, Rediform Concrete would do well not to make the proposed capital investment in the factory.
Rediform Concrete has identified a project that would involve a capital investment of $5 million into a factory that would manufacture formed concrete products; these would include patio stones, mobile home stoves and lawn decorations. The firm would like to know the viability of the project before undertaking it. This is because a large sum of money is involved and it is a strategic decision for company growth and financial strength.
The factory is expected to generate annual sales between $2million and $5million. After tax fixed costs are $500,000 annually while after tax variable costs are 50% of the expected annual sales. The expected life of the project is 5years. The factory has a residual value of either $3million or $1 million contingent on land prices at the end of 5years. Land prices are dependent on whether or not the new freeway exit for Sunshine Expressway is built on Palmetto Road, where the factory is to be located. If the freeway exit is on Palmetto Road, the residual value is $3 million; and if not, then it is $1 million. Due to this uncertainty, the firm would like to know what changes to expect depending on the residual value at the end of the five years.
Based on previous experience, Rediform Concrete estimates its firm specific level of risk to be 0.75; the expected market return is 12% and the risk free rate on government bills is 4%. This information will be useful in finding the total return on the assets, better known as the cost of capital.
The type of study in this case is evaluative. This is because we seek to find out the effects of a new factory on Rediform Concrete. Data used will be secondary- it will the data given from company records and previous analysis. Analysis of data will be done by finding the net present values and internal rate of return having used the two possible factory residual values for comparison.
A project is at break even point when it makes no losses or profits, that is, when its sales are totally able to cover the expenses incurred in production. Number of units sold to break even in this project will be calculated as follows:
Total sales = Total costs (fixed and variable)
We are told that sales range between $2 million and $5 million, average sales = =$3.5million
Letting the number of units sold to be x.
Equating the revenue and costs,
3,500,000 = 0.5x + 500,000
0.5x = 3,000,000
· x = 6,000,000
The number of units of formed concrete products that should be sold to break even is 6,000,000.
To find the present value of the project cash flows, we first calculate the weighted average cost of capital using CAPM:
RF + β (RM – RF)
4% + 0.75*8% = 10%
The weighted average cost of capital will be used to discount the cash flows expected over the project’s five years.
Table 3.2.1 below shows the calculations involved in finding the after tax operating cash flows of the factory. The annual sales used in the table used are the average of the range in which the annual sales are projected to fall, as earlier shown under the break even analysis.
Table 3.2.1
Year
1
2
3
4
5
Annual sales
3,500,000.00
3,500,000.00
3,500,000.00
3,500,000.00
3,500,000.00
After tax cash flow
1,750,000.00
1,750,000.00
1,750,000.00
1,750,000.00
1,750,000.00
Annual fixed costs
-500,000.00
-500,000.00
-500,000.00
-500,000.00
-500,000.00
Operating cash flow
1,250,000.00
1,250,000.00
1,250,000.00
1,250,000.00
1,250,000.00
Table 3.2.2 and 3.2.3 shows the calculations of the net present value of the project at WACC of 10% at the two different residual values of the factory respectively. They also indicate the internal rate of return of the project. Figure 1 and 2 are graphical representations of the present values over the five years.
Table 3.2.2
IF EXIT IS ON PALMETTO ROAD:
Year
0
1
2
3
4
5
Initial value
-5000000.00
3000000.00
Operating cash flow
1250000.00
1250000.00
1250000.00
1250000.00
1250000.00
Net cash flow
-5000000.00
1250000.00
1250000.00
1250000.00
1250000.00
4250000.00
PVIF @ 10%
1.00000
0.90909
0.82645
0.75131
0.68301
0.62092
Present Value
-5000000.00
1136363.64
1033057.85
939143.50
853766.82
2638915.62
NET PRESENT VALUE: $ 1,601,247.43
IRR : 8.70932%
Figure 1: Present values over the 5yrs at salvage value of $3million
Table 3.2.3
IF EXIT IS ON OTHER ROADS:
Year
0
1
2
3
4
5
Initial value
-5000000.00
1000000.00
Operating cash flow
1250000.00
1250000.00
1250000.00
1250000.00
1250000.00
Net cash flow
-5000000.00
1250000.00
1250000.00
1250000.00
1250000.00
2250000.00
PVIF @ 10%
1.00000
0.90909
0.82645
0.75131
0.68301
0.62092
Present Value
-5000000.00
1136363.64
1033057.85
939143.50
853766.82
1397072.98
NET PRESENT VALUE: $ 359, 404.78
IRR: 2.310996%
Figure 2: Present values over 5yrs at salvage value of $1 million
Discussion of results
The economic break even analysis
From the break even analysis above, in an accounting perspective, the number of units that should be sold to break even and make neither profit nor loss is 6,000,000. It is evident that a client cannot buy one single unit of the formed concrete products, which explains why a single unit costs less than a dollar. Thus, deciding the number of units to put in a batch that should be sold at a time would help the company meet its target more easily by reducing its costs of packaging and administration, especially if the number of units in a batch is high.
The break even analysis is an easy and useful tool in showing the dynamics between sales, profits and costs. The policymakers can use the information to come up with innovations that ensure the break even point is lower so as to reduce chances of making losses.
However, as much as the break even analysis is useful, its assumptions tend to break its usefulness. This is because it assumes that the all units produced will be sold and thus each unit will cover its own costs. This is probably never the case; companies will always have unsold stock or stock that is returned due to damage or warranty reasons. In addition, it overlooks the demand side of the equation by assuming that there are buyers who are willing to buy at the prices they set. It is not a predictor of demand. Thus it must be used cautiously because one does not know how consumers will react to their products if they have not launched the project yet.
Project’s sensitivity to residual value
Firstly, it is noteworthy that the firm’s beta is less than one, implying a good risk management system from within.
From the analysis above, the net present value and internal rate of return at the two residual values is as follows:
Residual value
Net present value
IRR
$ 3million
$ 1,601,247.43
8.70932%
$ 1million
$ 359, 404.78
2.310996%
As expected, at the higher residual value of $3 million, the net present value and internal rate of return are also higher. The construction of the freeway exit on Palmetto Road would cause the value of land to appreciate due to increased human traffic along the road which would result to the area becoming a goldmine of sorts for investors. As a result, the value of the factory would also increase hence increasing probable cash inflows from the company.
On the other hand, assuming activities continue as usual and nothing out of the ordinary occurs along the Palmetto road then the residual value is $1 million, which is lower by a margin of 66.667% when compared to when the freeway is constructed along the same road. Similarly, the net present value and IRR are lower. The net present value is lower by a margin of =77.555% whilst the IRR is lower by = 73.465%.
Summary table of margins
Margin
Residual value
66.667%
Net present value
77.555%
Internal rate of return
73.465%.
The margins are just too high especially if Rediform plans to invest with hopes only pegged on Palmetto Road having a freeway exit near it.
In addition to the high margins, both internal rates of return are lower than 10% which is the weighted average cost of capital, the return on equity. This means that their investment would be earning less than if they decided to reinvest in the company’s ordinary activities.
Conclusion
After conducting the above analysis, it is clear that Rediform Concrete would be taking a big risk investing in the factory. Given the high break even point from the break even analysis, and the uncertainty of demand levels, though predicted to range between $2 and $5 million, it may be too big a plunge for the company whose beta indicates that is either a low risk company or manages its risks very well. In addition, the sensitivity analysis indicated positive levels of net present value but the return is not very attractive, being lower than the return on assets of 10%.
Therefore, in conclusion, the analysis conducted shows that Rediform Concrete should not invest in the factory.
Operating Cashflows 0 1 2 3 4 5 -5000000 1136363.6363636369 1033057.8512396694 939143.50112697203 853766.81920633861 2638915.6230014088 Present values-salvage $1M 0 1 2 3 4 5 -5000000 1136363.6363636369 1033057.8512396694 939143.50112697203 853766.81920633861 1397072.9768830989 10
