The Investment Decisions of Britannia Company Finance Essay

INTRODUCTION:

The given case deals with the Britannia Company; the report is divided into four parts, the first part deals with the investment decisions of the company, which I should take by calculating the Net Present Value (NPV). The next part of the report deals with the calculation of the future cash flows of the project. The third part deals of the case deals with answering whether investment decisions of the company will decide the future of the company or not. And the final part of the case asked to evaluate why NPV is the best technique for the evaluation of the capital projects

PLANT AND MACHINERY

OPEN WDV [email protected]/* */% CLOSING WDV 1 500 125 375 2 375 94 281 3 281 70 211 4 311 78 233 5 233 58 175 6 175 44 131 7 131 33 98 8 98 25 74 9 74 18 55 10 55 14 42

BUILDING

OPEN EDV [email protected]/* */% CLOSING WDV 200 20 180 180 18 162 162 16 146 146 15 131 131 13 118 118 12 106 106 11 96 96 10 86 86 9 77 77 8 70 Here total depreciation is sum of depreciations calculated for PLANT AND MACHINERY, BUILDING, FURNITURE AND FITTINGSMOTOR VEHICLES. 1. A) If I was in the place of Mukesh, I totally don't agree with the company's management claim of justifying the value creation of the project on the share price.

1. B)

Step 1:

I calculated the NPV for the proposed project and observed that the spike in the share value was because the project was producing positive NPV. I would describe the process in which I have solved the problem or calculated NPV. Firstly I calculated the depreciation for different fixed assets except for the land. Different fixed assets are Plant and machinery. Buildings. Furniture. Motor vehicles. I calculated the depreciation of different fixed assets using the WDV method and then calculated the total depreciation by summing the individual depreciations.

Step 2:

Using the different variables, like number of units sold, selling price, variable cost and fixed cost, I calculated the total sales or revenue generated by the product over a time horizon of ten years. Now considering the initial cash flows which mainly consist of initial investment and working capital. In the project working capital is said to be considered as twenty percent of sales or revenue of that year. After calculating the working capital requirement for all the years it is preserved for calculating the change in working capital at the later stage. Now from sales or revenue variable cost, fixed cost and depreciation are subtracted so that we get the Earnings Before Interest and Tax (EBIT). EBIT represents the earnings of a company before paying interests to lenders and tax to the Government. Now I subtracted the corporate tax that has to be paid to the Government and according to the case corporate tax is given as thirty per cent. After that I added back the depreciation to the original figure, then subtracting additional capital expenditure, in the case additional capital expenditure was added in the fourth year, and subtracting change in working capital requirement. Then finally we arrive at net annual cash flows. The initial cash flows are the investments. The cash flows between the years one to nine are calculated as described in the above process. The terminal cash flows are the cash flows that we get at the end of the project life. The terminal cash flows are calculated by adding the salvage values of the fixed assets, except for land, and recovery of working capital. In this step two I calculated the annual cash flows for the project.

Step 3:

Calculating the cost of capital using the Capital Asset Pricing Model. The Formulae is: Cost of capital or interest rate = Risk free market Rate + Beta * (Average Market Return - Risk free market rate).

Step 4:

Calculating the cost of debenture using the Internal Rate of Return method. Here in the case the coupon amount is calculated as coupon amount = coupon rate * face value.

Step5:

Calculating the cost of debenture using the Internal Rate of Return method. Here the dividend amount is calculated as dividend amount = dividend rate * face value.

Step6:

Calculating the Weighted Average Cost of Capital using both Book Values and Market Values. WACC = We*Ke + Wp*Kp + Wd*Kd (1-T) We Æ’A  Weight of Equity share capital. Ke Æ’A  Cost of Equity share capital. Wp Æ’A  Weight of preferential share capital. KpÆ’A Cost of Preferential share capital. Wd Æ’A Weight of Debenture capital. KdÆ’A  Cost of Debenture capital.

Step7:

Using this Weighted Average Cost of Capital I calculated the NPV for the project. Here NPV means Net Present Value. C) I strongly recommend that Enam Securities should not buy the shares, this was drawn based on the above given calculations when the share price is 1540/-. Because at the current prize of 1400/- the net present value is 1376.17 cr and when divided by 10 cr the value is 137.6/-, this indicates that the current market price should increase by 137.6/- but the share price has gone by 140/- rupees

I totally agree with the given statement. Generally companies evaluate many investment decisions for expansion but the principle behind doing this is for taking a right decision so that the company will thrive.

Growth

The results of investment decisions lead into the future and have to be persisted for a longer period than the consequences of the current operating expenditure. A company's decision to invest in long term assets has decisive influence on the rate and direction of its growth. If the decision taken is wrong it can prove disastrous for the continued survival of the company; unprofitable or unwanted expansion of assets will result in heavy operating costs to the firm. On the other hand inadequate investment in assets would make it difficult for the firm to compete successfully and maintain its market share.

Risk

A long-term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky. Thus, investment decisions shape the basic character of a firm. Take an example of Tata group, the investment decision that the company took and its diversification into various sectors and were very right at that point of time and the succeeded as the largest private group in India, in terms of market capitalization and revenues.

Net Present Value:

Given that NPV seems to be telling us directly what we want to know, we might be wondering why there are so many other procedures and why alternative procedures are commonly used. We should keep in mind that we are trying to make an investment decision and that we are frequently operating under considerable uncertainty about the future. We can only estimate the NPV of an investment in this case. The resulting estimate can be very "soft," meaning that the true NPV might be quite different. Because the true NPV is unknown, the financial manager seeks clues to help in assessing whether or not the estimated NPV is reliable. For this reason, firms would typically use multiple criteria for evaluating a proposal. By considering an example, when Cisco systems decided whether to acquire the Linksys Group in 2003, it had needed to consider both the costs and the benefits of the proposed acquisition. The costs included the initial purchase price and the ongoing costs of operating the business. Benefits would be future revenues from sales of the Linksys products. The right way for Cisco to evaluate this decision was to compare the cash value today of the costs to the value today of the benefits by computing the NPV of this acquisition. Cisco should have undertaken the acquisition only if it had a positive NPV. A company has to decide whether to introduce a new product line. The new product will have startup costs, incoming cash flows and operational costs over six years. This project will have an immediate (t=0) cash outflow of $100,000 (which might include machinery, and employee training costs). Other cash outflows for years 1-6 are expected to be $5,000 per year. Cash inflows are expected to be $30,000 each for years 1-6. All cash flows are after-tax, and there are no cash flows expected after year 6. TheA required rate of returnA is 10%. The present value (PV) can be calculated for each year:

Year

Cash flow

Present value

T=0 frac{-100,000}{(1+0.10)^0} -$100,000 T=1 frac{30,000 - 5,000}{(1+0.10)^1} $22,727 T=2 frac{30,000 - 5,000}{(1+0.10)^2} $20,661 T=3 frac{30,000 - 5,000}{(1+0.10)^3} $18,783 T=4 frac{30,000 - 5,000}{(1+0.10)^4} $17,075 T=5 frac{30,000 - 5,000}{(1+0.10)^5} $15,523 T=6 frac{30,000 - 5,000}{(1+0.10)^6} $14,112 The sum of all these present values is the net present value, which equals $8,881.52. Since the NPV is greater than zero, it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is no mutually exclusive alternative with a higher NPV.

Conclusion and Recommendations:

The case says that Britannia Industries spent 10 cr for the research, this cost was not taken in any calculations because this is sunk cost. Sunk cost is considered as cost that cannot be reversed and irrespective of the use of that product the cost is incurred. This case helps Enam Securities to take the correct decision on whether to invest or not in the company's shares'. Based up on my calculations, the recommendations to the Enam securities is they should not buy the share because the market price should have been increased by 137.2/- only, but the announced market price has increased by 140/- ruppes, therefore there is no scope in buying the shares of the company. The company's cost of equity is very high that is close to 21% and it should reduce that. This case clearly explains the answer to the third question that is Investment decision of the company will decide the future growth, because the company wanted to invest in a new project their share prices have increased in a way the company is expanding and this project will up to certain extant will decide the future of the company. My learning, from accepting NPV as a superior for evaluation of capital projects, made me use NPV for the evaluation of this case. I used IRR, for finding the cost of capital, when there were equal cash flows and used NPV when there were unequal cash flows.

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