CAPITAL BUDGETING DECISION ANALYSIS

Introduction

On May 30, 2020, Boon Mee, Senior Vice President of Tiger Land Textiles Ltd (TLT), was preparing for a meeting with the management committee scheduled the next week. On his desk was a capital budgeting and investment proposal – a new product line of branded shirts that the committee was considering for launch. As the head of the finance department, Boon Mee was required to work along with his team on a detailed capital budgeting analysis and present the findings to the management committee for their approval. As per standard company practice, each capital budgeting and investment project was evaluated using the traditional Net Present Value (NPV) approach and the Internal Rate of Return (IRR) criterion for determining whether the company would undertake the project or not.

Boon had a lot to think about as he considered the analysis of the capital budgeting project using the traditional Net Present Value (NPV) approach and the Internal Rate of Return (IRR) criterion. What would be the basis for calculating the after-tax operating cash flows for the capital project? How would he arrive at the depreciation and working capital requirements for computing the NPV? What would be the basis for calculating the terminal year cash flows? With all these questions in mind, Boon decided to focus on the proposed capital budgeting project for the next few days.

Company Background

TLT is a small, privately owned clothing company based in Cheng Mai, Thailand. It was founded in 1995 by Chaisee Benjawan, a retired executive. Since then, the company had grown steadily by catering to local and foreign tourists and local high to middle income consumers in the Cheng Mai Region (CMR). The company recorded a stellar growth of 17% in its sales during the last financial year of 2018/19. With a healthy operating margin ratio and low leverage levels, the company had been able to grow its profits at a compounding annual growth rate of 5% during the last 10 years. With a good brand name and healthy financial metrics, the company was now looking to expand its footprint to new product lines.

Project Investment Proposal Details

The project is estimated to be of 10 years duration. It involves setting up new machinery with an estimated cost of as much as Thai baht (THB) 375 million, including installation. This amount could be depreciated using the straight-line method (SLM) over a period of 10 years with a resale value of THB13.5 million. The project would require an initial working capital of THB15.5 million. With the planned new capacity, the company would be able to produce 150,000 pieces of shirts each year for the next 10 years. In terms of pricing, each shirt can initially be sold at THB 900 a piece, which takes into account the target segment and competitor pricing. The project proposal incorporates an annual increase of 3% in the price of the shirt to compensate for inflationary impact. With regards to the raw material costs and other expenses, the project estimated the following details:

Raw material cost for manufacturing shirts at THB325 per shirt, slated to rise by 2.5% per annum on account of inflation. Other direct manufacturing costs at THB55 per shirt with an annual increase of 2.5% per annum on account of inflation.

Selling, general, and administrative expenses (including employee expenses) at THB 24 million per annum, expected to increase by 6% each year. Depreciation expense on the basis of SLM.

Tax rate was assumed to be 30%.

Funding

For funding of the expansion project, the promoters agreed to infuse 50% in the form of equity with the rest (50%) being financed from issue of new debt. Based on the current credit position and market scenario, new debt can be raised by the company at 12% per annum. Cost of equity was assumed to be 15%. The requisite discounting rate or weighted average cost of capital (WACC) for NPV and IRR calculations can now be calculated with the help of the above assumptions.

Demand Scenario

Although the project proposal estimates maximum annual production of 240,000 shirts, Saurabh decided to do capital budgeting analysis under two demand scenarios: Optimistic and Expected. The likely annual demand estimated under each scenario is as follows:

Discussion Questions

1. Why are capital budgeting decisions important for a business firm? Discuss their concept and significance (5 marks)
2. Discuss the types of information generally required for evaluating the capital budgeting decisions of a firm from a financial standpoint. (5 marks)
3. What is meant by the Net Present Value (NPV) technique? Discuss its key assumptions and calculation methodology (including an estimation of the discount rate). (5 marks)
4. Explain the concept of the Internal Rate of Return (IRR). What is the criterion generally used by firms while accepting or rejecting a capital budgeting project on the basis of the IRR technique? (5 marks)
5. On the basis of the financial information given in the case, calculate the after-tax operating cash flows, NPV, and IRR under the Optimistic and Expected scenarios. Clearly specify the calculations required for the same. (40 marks)
6. Based on your analysis, as Boon Mee, what recommendation would you make on whether the company should undertake the project or not? Clearly specify the decision based on both the NPV technique as well as the IRR criterion. (10 marks)

Further Reading

Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Abingdon, UK: Routledge.

Brealey, R., Myers, S. C., & Marcus, A. J. (1995). Fundamentals of corporate finance (p. 69), New York: McGraw-Hill.

Fabozzi, F. J., & Drake, P. P. (2009). Capital Budgeting Techniques. Handbook of Finance. Hoboken, NJ: John Wiley & Sons, Inc.

Gitman, L. J., & Forrester Jr, J. R. (1977). A survey of capital budgeting techniques used by major US firms. Financial Management, 6, 66–71.

Graham, J., & Harvey, C. (2002). How do CFOs make capital budgeting and capital structure decisions? Journal of Applied Corporate Finance, 15(1), 8–23


Harris, M., & Raviv, A. (1996). The capital budgeting process: Incentives and information. The Journal of Finance, 51(4), 1139–1174.

Myers, S. C. (1974). Interactions of corporate financing and investment decisions— implications for capital budgeting. The Journal of Finance, 29(1), 1–25

• Leading credit providers and other financial organisations have code of ethics, sometime called codes of conduct. Select one of them and summarise it by itemising its main principles.

• It is important to keep up to date with compliance requirements so that the required changes can be made to organization procedures and product offerings.  Suggest three sources that you can use.

• How could you prepare yourself to deal with client concerns?

• Give examples of the following legal breaches: breach of the duty of care, false and misleading conduct, unconscionable conduct & conflict of interest without disclosure. Put some real-life examples after the explanations

• What are the procedures for dealing with client complaints in your organisation?

• Briefly indicate the environmental protection assistance that your business organization is able to receive from your State (NSW) or Territory environment protection agency.

• What needs to be demonstrated at the outset in a client relationship? When is appropriate to demonstrate competence?

• Explain the importance of a code of ethics in the relationship between a professional and clients.

• Drawing on your own experience or the experience of a more experienced colleague or manager, describe a situation where a need was identified to use language and concepts appropriate to cultural differences. How was the need met?

• List two others type of professional your organization uses to develop client relationships and indicate in each case how it is able to provide them with a benefit in the relationship.

Task 7: Prepare a loan application on behalf of mortgage broking clients

Case Study — Evaluating and processing a loan application

Read the following case study then answer the questions that follow.

Ross and Melissa Cooper are a young couple who have been married for five years, during which they have been renting an apartment while saving to buy an apartment of their own. They do not have any children at this stage.

After some months searching, they have found a small two-bedroom apartment that suits their needs. The purchase cost of the property is $480,000, and they have provided a deposit of $60,000. You are recommending a standard variable loan.

Ross has been working at Gaines Consulting Pty Ltd. for 12 years and has a salary of $80,000. Melissa has been working at Jackson Equipment Hire Pty Ltd for 8 years and has a salary of $70,000. Neither has had previous employment, apart from casual work when they were younger.

The full details of Ross and Melissa that you have collected are as follows:

ASSETS AND LIABILITIES

Surplus/deficiency: $126,400          

OTHER DETAILS:

They are seeking a loan term of 25 years. Other requirements are:

• proposed settlement date — 6 weeks time
• ability to make additional payments from time to time without penalty
• monthly repayments
• redraw facility.

The applicants will have no other financial commitments other than their monthly mortgage commitments, rates and utility costs and strata fees.

The current variable home loan rate is 6% pa.

Note:  For the purposes of this assignment, any first home purchase assistance should be ignored.

OTHER INFORMATION

APRA is concerned that interest rates may rise and because of this it is requiring all lenders to “stress test” all housing loans at a borrowing rate of 7% p.a.

Task 7.1.

Apart from requiring the presentation of a Credit Guide, the NCCP Act says nothing about what a mortgage broker should say about him/herself at the beginning of a client interview. In the space below, make a few brief points about what you would say about yourself and your firm at this stage. Remember that at the outside the client is primarily looking for assurance that the broker is concerned about them and their interests.

Task 7.4.

Mortgage brokers should present adequate information to clients to enable them to make a choice between loans. This involves conducting research to determine suitable loans and presenting clients with a choice among, say, three loans that are considered to be suitable for the client’s requirements. The characteristics of the three selected loans are then presented to clients in a way that allows a comparison to be made. The presentation may be made a piece of paper, or other means such as a PowerPoint overhead. 

You are now required to use the internet or other sources to choose three loans from banks in AUSTRALIA that you believe will meet the requirements of Ross and Melissa. The relevant details should be placed in the spaces provided.

Task 7.5 (a)

Explain significant features of the loan products that you have chosen in words that the client would understand. Your answer should be restricted to features relevant to the clients.

Task 7.5 (b)

Credit providers always have other fees and charges beyond their stated interest rates. Select one of the best loans you have set out in Task 7.4 as the one preferred by Ross and Melinda, and explain any additional fees and charges in a manner that your clients can understand.

1. Capacity
2. What will the applicants’ monthly payment be, given the current variable lending rate of 6% p.a.? (Hint: visit a website such as: http://www.yourmortgage.com.au/calculators/).
3. Using the ‘income percentage method’, assess the applicants’ capacity to repay the loan (25 words)

• Collateral
• Assuming the valuation placed on the property is $480,000, calculate the loan to valuation ratio (LVR).
• Given the LVR that you have calculated, what steps might the bank take to protect its position? (25 words)

• Conditions

Using the information that has been presented, identify any ‘conditions’ that might impact on this loan application. How should they be handled?

Task 8.3.                                                                                                                                                           

Sometimes additional support, such as a third-party guarantee is required in housing loans. Indicate when such support may be required and the matters about which the credit provider should seek to be satisfied. How is the required evidence about those matters normally obtained?