FUNDAMENTALS OF VALUE CREATION IN BUSINESS

the assignment has to be done in the spreedsheet excel as well as additional work needs to be shown and all the questions need to be completed.

FBL5030 FUNDAMENTALS OF VALUE CREATION IN BUSINESS
SEMESTER 2, 2015
ASSIGNMENT 2 – FINANCE

Case Study in Finance – Nova Tractor Corporation

SUBMISSION REQUIREMENTS
 Due by 5pm Friday 30th October (week 13) through Turnitin
 MUST include the cover page (provided on our BB website). Please note that if an assignment cover sheet is not included your assignment will not be graded.
 The assignment must be submitted:
 as one document, and
 in one copy by the nominated group leader (if completed in a group)

CONTRACT INFORMATION
 If you complete the assignment in a group you should:
 submit a completed and signed FBL5030 assignment contract in person (on campus students) or via email (external students) before starting your teamwork
 submit an assignment peer review form in person (on campus students) or via email (external students) after submitting the assignment

ADDITIONAL INFORMATION
 Your assignment should be in the form of business report (please refer to the document provided). Your report should include:
a) Cover / Title page
b) An Executive Summary (word limit 300)
c) An introduction (not more than 150 words)
d) Findings and Discussion – Answers to the given questions written in the body paragraphs, with appropriate headings, subheadings, etc. This analysis should not exceed 1,200 words
e) A recommendations (not more than 200 words)
 Use a word processor to prepare assignment on A4 paper. Handwritten assignments will not be accepted
 Choose a legible font face and size (e.g. Times New Roman 12 or Arial 11 would be sufficient) and double-spaced your lines
 Aim for a professional level of document presentation and formatting
 Do not include a reference list in this assignment
 Support your answers given in the body of the report with relevant Excel workings and tables placed in the appendices. You will do this by copying all Excel tables and pasting them as a picture / screenshot in your Word document. This minimises the chance of a viewing error after uploading on Turnitin
 Observe the due date strictly. Extensions can only be granted with supporting documentation (e.g. medical certificate or court summons).

CASE STUDY IN FINANCE – NOVA TRACTOR CORPORATION
Nova Tractor Corporation owns and operates a transmission and axle plant which manufactures more than 50% of the transmissions and axles used in the complete line of tractors and harvesting equipment offered by Nova to the agricultural industry. With an extensive machining processes performed on the steel parts for the final transmission and axle assembly, a very large amount of steel shavings and bulky steel scrap is generated in this plant.

The unprocessed steel scrap is sold as a by-product of the manufacturing operation to various firms involved in the recycling process. The executive committee is currently evaluating whether to process the scrap into different grades and types of usable steel. Using different models of chip crushers, the scrap is grinded and compressed into either “rough” or “fine” scrap. The fine scrap fetches a higher market price than the rough scrap.

Nova has to decide whether to invest in the higher-cost chip crusher (HCC) to produce fine scrap or the lower-cost chip crusher (LCC) to produce rough scrap.

As a financial analyst of the company, you have gathered relevant purchase prices and operating costs of the two chip crushers from the supplier of the chip crushers and the marketing and production staff.

Key estimates of financial data for the two machines are shown in Table 1.

Table 1: Key Estimates of Financial Data
HCC LCC
Purchase Price $500,000 $400,000
Life (years) 6 4
Depreciation (reducing balance method) 40% p.a. 35% p.a.
Residual value at the end of the useful life $45,000 $25,000
Annual processed scrap revenue $580,000 $520,000
Working capital (% of scrap revenue) 10% 10%
Annual Operating Costs
– Overheads $140,000 $105,000
– Salaries $110,000 $80,000
– Marketing $58,000 $52,000

The estimates for annual operating costs include the following items:

i) The overheads include direct operating expenses incurred in the production of the fine or rough scrap and a fixed amount of $30,000 per annum to cover the Head Office overheads.
ii) Salaries for LCC represent the costs of employing two new machine operators at a salary of $40,000 per annum each. For HCC, the company would only need to employ a new machine operator at a salary of $40,000 per annum and the second, who earns $70,000 per annum, will be transferred from the axle assembly plant. If the transfer is not required, the second operator from the main plant would have been laid off with a redundancy payment of $50,000.
iii) The marketing cost is based on the standard allocation of the new investment towards group advertising expenses, which is 10% of annual processed scrap revenue. It has been estimated that the additional group advertising required promoting the sales of fine or rough scrap is only $40,000 per year.
Nova is a private company, soundly financed and consistently profitable. Cash and deposits are not sufficient to buy the chip crusher. However, Mr Jack Murray, the Chairman of Nova, is confident that the cost of the chip crusher could be financed with medium-term debt.

Preliminary discussions with Nova’s bankers led Mr Murray to believe that the firm could arrange a 12% 4-year term loan of $400,000 or 6-year term loan of $500,000 for LCC and HCC, respectively. The terms for both loans are repayment of fixed annual interest expense in advance and the principal owing at maturity. The company’s tax rate is 30%, and its nominal after-tax cost of capital is 15% per annum.

The accountant, Mr Peter Smith, pointed out to you that the revenue figures do not take into consideration the scrap sales that Nova would generate if the company did not buy either machine to process the scrap. He has estimated that the current unprocessed scrap would generate a net income of $120,000 per year.

Production facilities for the steel scrap would be set up in an unused section of Nova’s main plant. The section of the plant where the steel scrap production would occur has been unused for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, Nova spent $80,000 to rehabilitate that section of the main plant.

Smith believes this outlay, which has already been paid and expensed for tax purposes, should be charged to the steel scrap project. His contention is that if the rehabilitation had not taken place, the firm would have to spend $80,000 to make the site suitable for the steel scrap project. As the section of the plant has been rehabilitated, it could fetch a rental income of $36,000 per year.

Murray wanted to see some type of risk analysis on the project as it might be profitable, but what are the chances that it might turn out to be a loser. You met with the marketing and production managers to get a feel for the uncertainties involved the cash flow estimates. After several sessions, they concluded that there was little uncertainty in any of the estimates except for sales, which could vary widely. Past contracts agreed upon with several dealers indicate the future revenues from the sales of processed steel scrap could be higher or lower than the marketing staff had anticipated, depending on the market demand. In their opinion, the revenue projections for both LCC and HCC could deviate from its estimated values given in Table 1 by plus or minus 20%.

You also discussed with Andrew Frost, Nova’s director of capital budgeting, on the risk inherent in Nova’s average project and how the company typically would adjust for risk. Frost told you that, the firm has been adding or subtracting 3 percentage points to its 15% overall cost of capital to adjust for differential project risk. When you asked about the basis for the 3-percentage point adjustment, Frost stated that it apparently had no basis except the subjective judgement of John Newton, a former director of capital budgeting who was no longer with the company. Therefore, may be the adjustment should be 2 percentage points or may be 5 percentage points.

QUESTIONS
1. Prepare the cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) for each chip crusher using the information given in the case.

Which of the following items should be included as incremental cash flows in the table? Give reasons for individual items and list clearly your assumptions in deriving the figures.

a) Yearly interest expense on the fixed-term loan for each machine;
b) Working capital investment which is 10% of annual scrap revenue;
c) Annual operating costs (i.e. overheads, salaries and marketing) for each machine;
d) The $80,000 that was spent to rehabilitate the plan;
e) Net income of $120,000 per year from the sales of unprocessed scrap;
f) Rental income of $36,000 per year.

2. Which chip crusher (HCC or LCC) would you recommend Nova to purchase based on the payback period (PP), internal rate of return (IRR), net present value (NPV) and equivalent annual value (EAV) methods?
[Assume the company is able to invest in both chip crushers on the same terms indefinitely.]

3. Mr Murray requested risk analysis on the project so it is necessary to check which chip crusher (HCC or LCC) made financial sense before it is accepted.

a) Show a sensitivity analysis of NPVs (derived in Question 2) to changes in annual processed scrap revenue and cost of capital individually. Assume each of these variables can deviate from its estimated value by plus or minus 20%.
b) Determine how far the annual net operating cash flow could fall short of forecast before the chip crusher would be rejected.
c) After reviewing the data provided, you realised the revenue and cost figures have not been adjusted for inflation which is another source of uncertainty. Some people were talking about a zero long-term inflation rate, but you wondered what would happen if inflation is 2.5% per annum.

4. Consider all information given in the case study and the results derived in Questions 1 to 3. Advise the executive committee and Mr Murray on which chip crusher (LCC or HCC) they should invest.

5. Discuss the reasons for your recommendation and any reservations you may have in given this advice.

MARKING GUDE

QUESTION MARKS ALLOCATED
1. Prepare the cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) for each chip crusher using the information given in the case. 10 MARKS EACH = 20 MARKS
2. Which chip crusher (HCC or LCC) would you recommend Nova to purchase based on the payback period (PP), internal rate of return (IRR), net present value (NPV) and equivalent annual value (EAV) methods? 5 MARKS EACH = 10 MARKS
3. Mr Murray requested risk analysis on the project so it is necessary to check which chip crusher (HCC or LCC) made financial sense before it is accepted. 20 MARKS
4. Consider all information given in the case study and the results derived in Questions 1 to 3. Advise the executive committee and Mr Murray on which chip crusher (LCC or HCC) they should invest. 10 MARKS
5. Discussions – clear and relevant suggestions to management. 10 MARKS
Presentation, and ELP quality:
– Quality of document presentation
– Language, grammar and spelling 10 MARKS
MARKED OUT OF 80 SCALED TO 40% OF FINAL GRADE

NOTE THAT IN EACH CATEGORY ABOVE, MARKS WILL BE ALLOCATED ON THE BASIS OF ACCURACY OF COMPONENTS WITHIN THE CATEGORY.
E.G. MARKS WILL BE ALLOCATED FOR EACH ITEM IN YOUR CASH FLOW TABLE. THEREFORE IT IS IMPORTANT THAT YOU GIVE A COMPLETE BREAKDOWN OF EACH ITEM WITHIN THE CASH FLO

Reducing Balance Depreciation Method
Reducing Balance Depreciation Method has depreciation at a higher rate in the earlier years
of an asset. The amount of depreciation reduces as the life of the asset progresses.
Depreciation under reducing balance method may be calculated as follows:
Net Book Value x Rate% = Depreciation per annum
Where:
 Net Book Value is the asset’s net value at the start of an accounting period. It is
calculated by deducting the accumulated (total) depreciation from the cost of the fixed
asset
 Rate of depreciation is defined according to the estimated pattern of an asset’s use
over its life term
Example:
 An asset has a useful life of 3 years.
 Cost of the asset is $2,000.
 Residual Value is $500.
 Rate of depreciation is 50% p.a.
Depreciation expense for the three years will be as follows:
YEAR DEPRECIATION BOOK VALUE
ACCUMULATED
DEPRECIATION
0 $2,000 0 $2,000 0
1 $2,000  50% $1,000 $1,000 $1,000
2 $1,000  50% $500 $500 $1,500
3 $500  50% $250 $250 $1,750
As you can see from the above example, depreciation expense under reducing balance
method progressively declines over the asset’s useful life.
TAX SAVINGS ON CAPITAL GAIN/LOSS
Tax paid on capital gain, or
Tax savings on capital loss  30% of asset Disposal Value

Asset Disposal Value  Residual Value – Book Value
Cont. above example:
Asset disposal value  $500 – $250 = $250
If Book Value < Residual Value  capital gain If Book Value > Residual Value  capital loss

File C5-241
August 2013
www.extension.iastate.edu/agdm
Don Hofstrand
retired extension agriculture specialist
agdm@iastate.edu
Constructing a Capital Budget
A capital budget can be used to analyze the
economic viability of a business project
lasting multiple years and involving capital
assets. It is divided into three parts. The fi rst
part is the initial phase in which capital assets such
as machinery and equipment are purchased and a
production facility is constructed. The second phase
involves estimating a series of operating cash fl ows
that generate annual returns from the project. These
operating cash fl ows extend over the life of the business
project. The third phase occurs at the end of the
project and involves liquidating the remaining assets
and closing the business project.
Estimating Operating Cash Flows
The process for computing operating cash fl ows
is shown below. Operating cash fl ows are usually
estimated for monthly, quarterly, or annual time periods.
First, cash revenues are estimated. This usually
involves estimating the number of units sold during
each time period and multiplying the number by the
selling price of the units.
The next step is to estimate the cash expenses associated
with making the product. Cash expenses
are categorized as variable and fi xed cash expenses.
Variable cash expenses are tied directly to the
amount of output produced. For example, if it takes
10 pounds of raw materials to make one unit of
output, then the cost of raw materials varies in direct
proportion to the amount of output produced. Fixed
cash expenses are those that don’t vary according
to the amount of output produced. For example,
administrative expense is often a fi xed expense
because it is constant regardless of the amount of
output produced.
Depreciation of the capital assets is computed next.
Depreciation and cash expenses are then subtracted
from cash revenues to compute net income before
taxes. The income tax rates are applied against the
net income before taxes to compute the amount of
taxes. The taxes are subtracted from net income
before taxes to compute net income after taxes. Because
depreciation is a non-cash expense, it is added
back to net income after tax to compute cash fl ow
after tax.
The relevant cash fl ows generated from this process
for use in capital budgeting are cash revenues, cash
expenses, taxes, and net cash fl ow after taxes.
Capital Budgeting Example
A simplifi ed example of capital budgeting for a business
project is shown in Table 1. The initial investment
includes outlays for buildings, equipment, and
working capital. $110,000 of cash revenue is projected
for each of the 10 years of the project. After variable
and fi xed cash expenses are subtracted, $50,000
of net cash fl ow (before taxes) is generated.
Computing Cash Flow after Taxes Relevant Cash Flows
Cash Revenue + $ 10,000 Cash Revenue + $ 10,000
Cash Expenses – $ 5,000 Cash Expenses – $ 5,000
Depreciation – $ 2,000 Net Cash Flow Before Taxes = $ 5,000
Net Income Before Taxes = $ 3,000 Taxes – $ 1,000
Taxes – $ 1,000 Net Cash Flow After Taxes = $ 4,000
Net Income After Taxes = $ 2,000
Depreciation + $ 2,000
Cash Flow After Taxes = $ 4,000
Page 2 File C5-241
Depreciation on the buildings and equipment used in
the project is computed and used to compute the tax
liability. For the fi rst seven years, taxes are $7,500,
resulting in net cash fl ow after taxes of $42,500 per
year. The equipment is completely depreciated after
seven years, resulting in higher taxes and net cash
fl ow after taxes of $40,000 for years eight and nine.
Although not included in the example, price and cost
coeffi cients can be adjusted for infl ation and over the
time period.
At the end of 10 years, the project ends. The market
value of the buildings and equipment is $110,000.
Adding the return of the $30,000 of working capital,
the cash infl ow is $140,000. Because the equipment
has a market value of $10,000 but is completely
depreciated, $10,000 of depreciation is required to
be repaid (recaptured). The recaptured depreciation
increases the taxable income, which increases the
amount of tax and reduces the net cash fl ow after
tax to $37,500. When the net cash fl ow for all three
phases are totaled and discounted, the net present
value of the project is $64,315. So, the business
project is expected to provide a net cash return of
$64,315.
Instead of ending the business, the equipment can
be replaced at the end of the 10 years and the business
continued. But for capital budgeting planning
purposes at the beginning of the project, the 10-year
period provides a good assessment of economic viability.

Cash Flow, Not Profi tability
Capital budgeting is based on the projected cash
fl ows of a project, not its projected profi tability. AlTable
1. Capital Budgeting Example
Discount Rate = 7% Tax Rate = 25%
Year
0 1 2 3 4 5 6 7 8 9 10
Beginning Cash Flows
Real Estate ($200,000)
Equipment ($70,000)
Working Capital ($30,000)
Total ($300,000)
Operating Cash Flows
Volume of Sales 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000
Sale Price $2.20 $2.20 $2.20 $2.20 $2.20 $2.20 $2.20 $2.20 $2.20 $2.20
Cash Revenue $110,000 $110,000 $110,000 $110,000 $110,000 $110,000 $110,000 $110,000 $110,000 $110,000
Variable Cash Costs ($35,000) ($35,000) ($35,000) ($35,000) ($35,000) ($35,000) ($35,000) ($35,000) ($35,000) ($35,000)
Fixed Cash Costs ($25,000) ($25,000) ($25,000) ($25,000) ($25,000) ($25,000) ($25,000) ($25,000) ($25,000) ($25,000)
Cash Flow (before tax) $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000
Building Depre. (20 yrs.) $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000
Equip. Depre. (7 yrs.) $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $0 $0 $0
Depreciation Recapture $0 $0 $0 $0 $0 $0 $0 $0 $0 $10,000
Taxes ($7,500) ($7,500) ($7,500) ($7,500) ($7,500) ($7,500) ($7,500) ($10,000) ($10,000) ($12,500)
Cash Flow (after tax) $42,500 $42,500 $42,500 $42,500 $42,500 $42,500 $42,500 $40,000 $40,000 $37,500
Ending Cash Flows
Cash Value of Buildings $100,000
Cash Value of Equipment $10,000
Return of Working Cap. $30,000
Total $140,000
Net Cash Flow ($300,000) $42,500 $42,500 $42,500 $42,500 $42,500 $42,500 $42,500 $40,000 $40,000 $177,500
Present Value CF ($300,000) $39,720 $37,121 $34,693 $32,423 $30,302 $28,320 $26,467 $23,280 $21,757 $90,232
Net Present Value $64,315
File C5-241 Page 3
though closely related, cash fl ow and profi tability are
different. Cash fl ow represents the cash infl ows and
outfl ows from the business. Profi tability represents
the income and expenses of the business.
You may think of cash fl ow as transactions that
affect your business “checkbook” and profi tability
as items that impact your “income tax return.” For
example, the purchase of capital assets results in
different transactions. Cash fl ows include the initial
outlay for capital assets and their sale at the end of
the project, whereas profi tability expresses the cost
of capital assets in a series of annual depreciation
expenses over the life of the assets.
Discount Rate
The discount rate used in the analysis should re-
fl ect the cost of capital. If the project is fi nanced
entirely with debt capital, the discount rate will be
the interest rate charged by the lender. If the project
is fi nanced entirely with equity capital, the discount
rate may be the opportunity cost of the funds. For
example, the opportunity cost may be the rate of
return the funds would have earned invested elsewhere.
If both equity and debt are used, the interest
charged on the borrowed money and the opportunity
cost rate of return may be blended in computing the
discount rate.
If the discount rate is designed to represent the cost
of capital for the business project, interest expense
should not be included as an operating cash fl ow.
If it is, interest (the cost of capital) will be counted
twice.
Working Capital
Working capital represents the money required to
fund the annual operating cash fl ow. When creating
a capital budget, it is important to allow for funds
to provide adequate liquidity for operations. At the
beginning of the business project, working capital
is a cash outfl ow just like the purchase of capital
assets. At the end of the project, working capital is
a cash infl ow just like the sale of the capital assets.
The amount of working capital remaining at the end
of the project may not be the same as the working
capital invested at the beginning of the project.
A related issue is the capital needed to get the business
project up and running. In many situations, the
time period from the initial purchase of equipment
until the facility is completed and running at capacity
can be long. Funds are needed to bridge this time
period.
Another issue is working capital in the form of
contingency funds needed to cover any unexpected
occurrences. These can include cost overruns, underperformance
of the facility, a market downturn, and
many other unexpected occurrences.
Lag Time in Converting Inputs to
Outputs
In many traditional manufacturing and processing
business projects, there is a relatively short time
between when inputs are purchased and outputs are
produced. For example, corn can be converted into
ethanol rather quickly. Once production begins, outputs
are produced in the same time period as inputs
are utilized.
However, for many agricultural production business
projects, there is a considerable lag time from the
time the input is utilized until output is produced.
For example, it may take several months for a feeder
calf to be converted into a fi nished animal. From
the time inputs (feeder calf) are purchased, outputs
(fi nished animal) may not emerge until the following
year. In this situation, the fi rst time period will
generate cash outfl ows (feeder calf purchase) but
no cash infl ows (fi nished animal sale). Therefore,
additional working capital is needed to fi nance this
lag time. Also, during the last year of the projects,
the situation is reversed because no inputs (feeder
calf) are purchased but outputs (fi nished animal) are
produced.
Page 4 File C5-241
Expansion versus Stand-alone Business
Project
Business projects are primarily of two types – the
expansion of an existing business and the start-up
of a new stand-alone business. Expansion examples
include an expansion of your main product line,
adding a new product line, making a component
versus buying the component, and a host of other
ways of expanding a business. The other is a standalone
business project. This is often a new start-up
business that has no direct connection to an existing
business.
The purpose of the capital budgeting exercise for a
business expansion is to determine if the expansion
will generate positive cash returns for the existing
business. When computing cash fl ows for a business
expansion, only those cash infl ows and outfl ows
associated with the expansion are included. The cash
fl ows of the existing business need not be included.
These additional cash fl ows are sometimes called incremental
cash fl ows because they often represent an
increase is an existing cash fl ow (e.g. more product
sales, larger purchase of raw materials, more marketing
expense, etc.). An expansion can lead to new
and additional cash fl ows that are diffi cult to detect.
A careful assessment is required to identify all cash
fl ows.
The purpose of the capital budgeting exercise for a
stand-alone business is to determine if the business
investments will generate a positive net cash return
over the life of the project. When preparing a capital
budget, all of the cash infl ows and outfl ows over the
life of the business project need to be included. This
includes the initial cash outlays at the beginning of
the project, the operating cash fl ows that occur annually
over the life of the project, and the remaining
cash value of assets at the end of the project.
Assessing Risk
Because capital budgeting involves projecting cash
fl ows several years into the future, there is considerable
risk as to the accuracy of these projections,
especially for those years farthest into the future.
This variability of outcome can have a major impact
on the outcome of the analysis and the resulting
feasibility of the business project. Several methods
have been developed to assess this variability and its
impact on the analysis.
Discount Rate
One method for accounting for the risk is to increase
the discount rate. This is similar to the way banks
account for high-risk loans by increasing the interest
rate. Essentially, it means that the bank needs to
receive a higher return to offset the higher risk of
default on the loan.
Table 2 shows the impact on net present value of the
example in Table 1 from raising the discount rate to
10 percent and 13 percent. A higher discount rate
will generate a smaller net present value.
Table 2. Impact of Risk Adjusted Discount
Rate on Net Present Value
7 percent (base analysis) $64,315
10 percent $10,966
13 percent ($31,388)
Sensitivity Analysis
Sensitivity analysis is another method of assessing
business risk. It shows how a change in one of the
Table 3. Impact of Sensitivity Analysis on Net Present Value
Volume
of Sales
Variable Cash
Expenses
Fixed Cash
Expenses
Discount
Rate
20% higher $180,204 $27,441 $37,976 $37,845
Base Analysis $64,315 $64,315 $64,315 $64,315
20% lower ($51,575) $101,188 $90,653 $93,958
File C5-241 Page 5
major operation variables impacts returns. Expressed
differently, it shows how sensitive the level of
returns is to a change in each of the major variables.
Table 3 shows the impact of a positive and negative
20 percent change in major variables on the net present
value of the project described in Table 1.
Scenario Analysis
Scenario analysis is similar to sensitivity analysis
except that one or more threats to and opportunities
for the business project are identifi ed, and how
these threats and opportunities might impact returns
is estimated. Examples of outside threats include the
entry of a competitor into the market, a sudden rise
in energy or raw material prices, a new technology
breakthrough by a competitor, an economic recession,
etc. Examples of inside threats include cost
overruns during startup, poor market development,
. . . and justice for all
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Issued in furtherance of Cooperative Extension work, Acts of May 8 and November 30, 1914,
in cooperation with the U.S. Department of Agriculture. Cathann A. Kress, director, Cooperative
Extension Service, Iowa State University of Science and Technology, Ames, Iowa.
poor quality control, etc. Scenario analysis is often
created in “best case” and “worst case” scenarios
based on opportunities for and threats to the business.
Table 4 shows the net present value of the
example in Table 1 using scenario analysis.
Table 4. Impact of Scenario Analysis on
Net Present Value
Best Case $132,643
Base Analysis $64,315
Worst Case ($10,427)