Corporate Finance Decision Making (Essay Sample)

Corporate Finance Decision Making Student’s Name Institution Affiliation Course Details Instructor’s Name Date of Submission Corporate Finance Decision Making Evaluation of the Proposed Project Businesses are mandated to fulfil the sole role of profit maximisation for shareholders while providing high-quality services to consumers. Due to the high risk of starting a new project, it is prudent to perform different evaluations to determine its feasibility. Project feasibility is determined by the value addition brought by the project and the returns that will be received by operating the project (Mesly, 2017). To assess the feasibility of the Milton Mining Company’s project, which has received a request from an Indonesian company to supply aluminium to them for the next ten years, Milton Mining must integrate the capital budgeting methods before making the decision. Capital budgeting methods are various techniques that can be applied to determine the economic feasibility of an investment. The methods are applied before the investment is made, and they play a pivotal role in decision-making as they aid in comprehending the expected returns from the project. Also, the methods assist the management in selecting an investment that will maximise shareholders' wealth in the long term when there are multiple investments that the business has an option to invest in. The most effective and pragmatic capital budgeting methods include the payback period, Net Present Value (NPV), and the Internal Rate of Return (IRR) (Garrison et al.,2021). Each of these methods offers invaluable insights and advantages on the feasibility of an investment. However, each method has its limitations, which must be considered before using it in financial decision-making. Payback Period The payback period is a monumental capital budgeting tool. It provides vital information on the time it will take for an investment to generate enough cash flow to cover the initial capital outlay. It is essential because it allows for the time it will take for the investment to return the initial capital, which marks the break-even point of the investment (Reniers et al.,2016). Therefore, the tool only provides information on how long it will take for the investment to return the initial stake the company invested. However, the method has severe limitations, which makes it prudent to incorporate other capital budgeting tools. Firstly, the tool ignores all the costs involved in running the investment and only considers how long it will take to reclaim the initial investment (Gao & Wong,2017). Therefore, it does not evaluate the profitability of a business as it only considers the cash flows generated from the investment, which may not be adequate to cover the costs. Also, it ignores the time value of money and the opportunity cost, which can lead to sub-optimal decision-making. The Net Present Value (NPV) Net present value entails the difference between the present value of the cash inflows and the present value of the cash outflows over time. The tool is used in capital budgeting and investment planning to determine a project's profitability. Unlike the payback period, NPV considers the time value of money, making it a more comprehensive and accurate measure of a project’s profitability (Gallo,2014). Under the NPV method, future cash flows are discounted to their present value using a specified discount rate, typically the firm's cost of capital. A projected value addition by the investment is denoted by a positive net present value (NPV), whereas a negative NPV implies the opposite. This approach is generally considered more effective because it aligns with the goal of maximising wealth. However, despite its comprehensive and accurate measures to display investment profitability, the method has severe limitations. The accuracy of NPV is highly dependent on precise estimation of cash flow predictions and an appropriate discount rate, which can be challenging to determine. This approach assumes a consistent discount rate throughout the project, disregarding any potential capital cost fluctuations. Moreover, the Net Present Value (NPV) may not accurately measure investments' strategic worth or adaptability, such as potential opportunities for future expansion. Ultimately, the complexity and lack of intuitiveness of NPV can provide challenges for stakeholders in comprehending and endorsing the decision-making process exclusively relying on NPV. Internal Rate of Return Internal Rate of Return represents the annual rate of growth that an investment is projected to generate. It works the same way as the net present value; the only difference is that it sets the net present value to zero. Projects with higher IRR than the company’s expected rate of return are deemed feasible and acceptable (Patrick & French,2016). However, the method has adverse limitations when there are non-conventional cash flows or multiple IRRs, as it can be misleading on the growth rate an investment is projected to generate. Also, this method assumes the reinvestment at the unpragmatic IRR rate. Calculations using the Capital Budgeting Methods Payback Period Calculation Initial Investment: $600,000 Fixed Costs: $100,000 annually Depreciation: $60,000 Variable Costs: $1400 per ton Revenue from the Contract: 400 tonnes at $1200 per ton, increasing by 2% annually Revenue from Excess production: 100 tonnes at $2100 per ton Tax Rate: 25% Cash Flow Calculation Year 1 Revenue from Contract: 400 * 2200 = $880,000 Revenue from excess production: 100 * 2100 = $210,000 Total Revenue: 880,000 + 210,000 = $ 1,090,000 Variable Costs: 500 * 1400 = $700,000 Fixed Costs: $100,000 Depreciation= $60,000 Total Costs: $860,000 Operating Income: 1090000 – 860000 = $230,000 Tax = 0.25 * 230,000 = $57,500 Net Income = 230,000 – 57,500 = $172,500 Add back depreciation of $60,000 Cash flow for year 1= 172,500 + 60,000 = $232,500 Year 2 Revenue from Contract: 400 * 2244 (Increase by 2%) = $897,600 Revenue from excess production: 100 * 2100 = $210,000 Total Revenue: 897,600 + 210,000 = $ 1,107,600 Variable Costs: 500 * 1400 = $700,000 Fixed Costs: $100,000 Depreciation= $60,000 Total Costs: $860,000 Operating Income: 1107600 – 860000 = $247,600 Tax = 0.25 * 247600= $61,900 Net Income = 247600 – 61,900 = $185,700 Add back depreciation of $60,000 Cash flow for year 1= 185,700 + 60,000 = $245,700 Year 3 Revenue from Contract: 400 * 2288.88 = $915,552 Revenue from excess production: 100 * 2100 = $210,000 Total Revenue: 915552 + 210,000 = $ 1,125,552 Variable Costs: 500 * 1400 = $700,000 Fixed Costs: $100,000 Depreciation= $60,000 Total Costs: $860,000 Operating Income: 1125552 – 860000 = $265552 Tax = 0.25 * 265552 = $66,388 Net Income = 265552 – 66388 = $199,164 Add back depreciation of $60,000 Cash flow for year 1= 199164 + 60,000 = $259,164 The total cash flow in three years is $737,364, and therefore, the payback period is three years. Payback Period: 2 + ((600,000 – 478,200)/259164) = 2.47 Years NPV Cashflow for Year 1= $232,500 Year 2 = $245,700 Year 3 = $259,164 Year 4 = $272,897.28 Year 5 = $ 286,905.23 Year 6 = $ 301,193.34 Year 7 = $ 315,767.21 Year 8 = $330,632.56 Year 9 = $345,795.22 Year 10 = $361,261.13 The cash flows above are calculated from the cash flows in the first three years, which had already been calculated, finding 2% on each and adding it up to the following year. NPV = Summation (CFt / (i+r)t) – Initial Investment PV 1 = 232,500/ (1.20)1 = $193,750 PV 2 = 245,700/ (1.20)2 = $170,625 PV 3 = 259,164 / (1.20)3 = $149,979.17 PV 4 = 272,897.28 / (1.20)4 = $131,605.56 PV 5 = 286,905.23 / (1.20)5 = $115,300.78 PV 6 = 301,193.34 / (1.20)6 = $100,869.04 PV 7 = 315,767.21 / (1.20)7 = $88,124.83 PV 8 = 330,632.56 / (1.20)8 = $ 76,894.57 PV 9 = 345,795.22 / (1.20)9 = $67,017.43 PV 10 = 361,261.13 / (1.20)10 = $ 58,345.69 Total PV = 1,152,512.07 NPV = 1,152,512.07 – 600,000 = 552512.07 IRR IRR is the rate which makes the NPV to be 0 0 = 1,152512.07/ (1+irr)10 – 600,000- Take 600,000 on the other side 600,000 = 1,152512.07/ (1+irr)10 – Multiply both sides by (1+irr)10 600,000 (1+irr)10 = 1,152512.07- divide both sides by 600,000 (1+irr)10 = 1.921. Find the tenth root 1 + irr = 1.06746 Irr = 0.6746 – convert to percentage IRR = 6.75 % Sensitivity Analysis At 30% NPV = Summation (CFt / (i+r)t) – Initial Investment PV 1 = 232,500/ (1.30)1 = $178,846.15 PV 2 = 245,700/ (1.30)2 = $145,384.62 PV 3 = 259,164 / (1.30)3 = $117,962.68 PV 4 = 272,897.28 / (1.30)4 = $95,548.92 PV 5 = 286,905.23 / (1.30)5 = $77,271.92 PV 6 = 301,193.34 / (1.30)6 = $62,400.09 PV 7 = 315,767.21 / (1.30)7 = $50,322.66 PV 8 = 330,632.56 / (1.30)8 = $40,532.07 PV 9 = 345,795.22 / (1.30)9 = $32,608.35 PV 10 = 361,261.13 / (1.30)10 = $26,205.21 Total PV = 827,082.67 NPV = 827,087.67 – 600,000 = 227,082.67 At 40% NPV = Summation (CFt / (i+r)t) – Initial Investment PV 1 = 232,500/ (1.40)1 = $166,071.43 PV 2 = 245,700/ (1.40)2 = $ 125,357.14 PV 3 = 259,164 / (1.40)3 = $ 94,447.52 PV 4 = 272,897.28 / (1.40)4 = $71,037.33 PV 5 = 286,905.23 / (1.40)5 = $ 53,345.56 PV 6 = 301,193.34 / (1.40)6 = $40,001.58 PV 7 = 315,767.21 / (1.40)7 = $29,955.10 PV 8 = 330,632.56 / (1.40)8 = $22,403.78 PV 9 = 345,795.22 / (1.40)9 = $16,736.58 PV 10 = 361,261.13 / (1.40)10 = $ 12,489.38 Total PV = $631,845.40 NPV = 631,845.49 – 600,000 = 31,845.49 Analysis, Evaluation, and Synthesis of Project Evaluation Results The capital budgeting tools provide invaluable information on the viability of the project. The payback period provides the time it will take for the project to return the initial investment. Based on the calculations, the project will return the initial investment after 2.47 years for Milton Mining Company. The time it will take is immensely short and shows how plausible the project...