Capital Budgeting Analysis Equator Ltd

Questions: 1. Calculate the NPV, Non-discounted Payback, and the IRR of Plant A and Plant B. Interpret your results. (If relevant, state any assumptions you have made.) 2. Describe and analyse 4 keys risks associated with the project you recommend (Project A or B). 3. Briefly define an efficient capital market. To what extent is Equators ability to borrow funds in the capital market dependent upon the capital market operating in an efficient manner? Answers: 1. Equator Ltd. is considering expanding its operations into tablet computers. The company has two options. The first option is Plant A which is highly automated but involves huge capital investment but has low running costs. The other option Plant B is more labour intensive and thus requires low capital investment but has high running costs. An analysis was undertaken for both the options with the help of capital budgeting techniques like NPV, IRR and payback. The results of the above techniques are presented below: Plant A Plant B NPV $2,56,71,833.0 $1,18,89,346.5 IRR 20% 18% Payback period 3.7 years 3.4 years (Calculations in Annexure) On the basis of the above results, the company should go ahead with Plant A as it has higher NPV and also higher IRR. Even though Plant A has longer payback period as compared to Plant B, but still is advisable to go ahead with Plant A due to higher NPV. Under capital budgeting, for mutually exclusive projects, the project with higher NPV is preferred against all other techniques of capital budgeting. Assumptions For discounting the cash flows, we have taken the cost of capital as 13.35% which is the real WACC used by the Computer tablet industry against the nominal WACC of 13% of the company. This is because the WACC should incorporate the risks involved in the project, and since this project relates to the tablet computers, the WACC of that industry should be considered. We have assumed that the working capital is recovered at the end of the project. 2. Capital Budgeting decision is based on estimating the future cash flows which is uncertain. This uncertainty calls for risk in a capital budgeting project. The various risks that may be involved in the recommended project include: a) Industry specific risk the company is undertaking the project based on the increasing industry demand for tablet computers. There is a risk that the tablet computer industry may face a major change like a change in the policies and regulation which may adversely impact the companys product. Also a major technological advancement which may render tablet computers as a thing of the past and thus the whole investment may go for a toss (Dontigney, NA) b) Project specific risk the project specific risk relates to inaccurate estimation of the future cash flows. The whole analysis of the project is based on the estimation of cash flows, if the estimation goes wrong, the capital budgeting analysis may also go wrong. c) Market risk market risk include the general economic conditions that affect all the firms in the market. In the above project, the sales units are projected on the basis of economic growth rate and the price of the product has been predicted on the basis of inflation rate. If these figures vary from what has been assumed, then the results of the analysis will completely change and the project may become non profitable. These risks are not under the control of the company (Drake, NA) d) Company specific risk any change in the company like the management of the company or strikes and lockouts which may affect the companys operations may disrupt the companys business and thus the revenue may be affected. 3. Efficient Capital Market is said to exist when the prices of the securities fully reflect the relevant publicly available information of the company. This means the price of the share reflects its intrinsic value. The theory generally applies to shares of a company. The price of the share represents the present value of all the future cash flows the investor of the security expects to receive in the future (Jones, Netter, NA). Such markets are said to exist because any undervalued or overvalued stocks motivate the traders to trade and this leads to movement of the price towards its intrinsic value. Thus the trading makes the capital market efficient. Also the efficiency in capital markets is dependent on other factors like transaction costs. If the transaction costs are low, there will be efficiency in the market as it is very easy and cheap to obtain information about the company, resulting in accurately priced shares. Like U.S is said to have an efficient capital market because of low transaction costs. The ease of information availability is due to the advancement in the technology and the organized capital markets. The capital markets are classified into three forms based on the speed and accuracy with which the new information gets incorporated in the security prices. The three forms of capital markets are weak form of efficiency, semi strong form of efficiency and strong form of efficiency. Weak form of efficiency is said to exist if the share price fully reflect the available past information about the security. This means if a capital market is in weak form, the investors cannot make profit on the basis of past prices and returns as these are already incorporated in the price. This makes technical analysis useless in weak form of market. Under semi strong market efficiency, the price of the security full reflects all the available information. However, an insider may make profits based on the insider information which is not available publicly but is fundamental to the company. Also a superior analyst can profit from trading by better interpretation of the public information. Under strong f orm, all the fundamental information about the company is reflected in the share prices including the secret ones. Thus no one can gain from trading on public or non public information. Fundamental analysis renders useless in this form of market efficiency. The role of a capital market is to move idle funds of the investors to the firms which require these funds to finance their investments. It is very important to have an efficient capital market if the funds are to be channelized to high value projects. The motive of an investor is make profits by investing in a companys shares. If the shareholder is assured that the project will increase the value of the company, he will invest in the project. The price of the shares will be fixed by the market depending on the expected future value of cash flows from the project. Hence, it will be very easy for the company to raise funds in an efficient capital market as the market determines the price at which the existing and potential investors will undertake the risk of the future cash flows. Moreover, these funds are available for long term projects (Jones, Netter, NA). Since a tablet computer is a growing industry, the market sentiments are good about this project and hence investors will be willing to invest in such projects as they promise high returns (Dudley, Hubbard, 2004). In an efficient capital market, Equator Ltd. will be able to easily raise funds through equity at the market determined prices. References Drake, P., (NA), Capital Budgeting and Risk, accessed online on 1st February, 2017, available at https://educ.jmu.edu/~drakepp/principles/module6/cbrisk Dontigney, E., (NA), What Factors Increase the Riskiness of a Capital Budgeting Project? Accessed online on 1st February, 2017, available at https://yourbusiness.azcentral.com/factors-increase-riskiness-capital-budgeting-project-26421.html Jones, S.L, Netter, J.M., (NA), Efficient Capital Markets, accessed online on 1st February, 2017, available at, https://www.econlib.org/library/Enc1/EfficientCapitalMarkets.html Dudley, W.C., Hubbard, R.G., (2004), How Capital Markets Enhance Economic Performance and Facilitate Job Creation, Global Market Institute, Goldman Sachs