WePROMOTE Continuing Analysis
WEPROMOTE CONTINUING ANALYSIS
I have been tasked with continuing calculations for my partner and our company, WePROMOTE. We are a promotional materials business which have been asked to create a phone case which will be used to promote our client and given away for free at their promotional events. Our client is a very prominent business in our local area and the product we may work on together is unique. It not only is good-looking and fits almost all phones, but it is also very strong. From this it could be assumed to be a very popular item among our clients' customers, which could then in turn reflect positively on us for manufacturing such a high-quality product.
However, a quality product does not necessarily mean the idea will be profitable for our company. In the following paper I will perform NPV calculations, explain the results, and draw a conclusion as to whether or not we should proceed with the investment.
The first step to determining NPV for a capital budget is creating a data block. As the name implies, this is simply a summary of the relevant information in an easier-to-read format than a large paragraph of text. For my own purposes, I have separated it into two data blocks; one which will affect the income positively and one which will affect the income negatively (Borosky & Business Plan, 2017).
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Positive Income Impacts
Year 0 Loan
105,000
Year 1 Revenue
$25,000
Year 2 Revenue
$27,000
Year 3 Revenue
$27,000
Year 4 Revenue
$28,000
Year 5 Revenue
$23,000
Salvage
$5,000
Negative Income Impacts
Year 1 Cost
$13,000
Year 2 Cost
$12,000
Year 3 Cost
$12,000
WEPROMOTE CONTINUING ANALYSIS
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Year 4 Cost
$12,000
Year 5 Cost
$10,000
Annual Interest Cost*
$3,150
Bank Loan Repayment
$105,000
There are two figures which are not taken into account in the figure above which are very important. The first is the tax percentage, which is 30% annually. The other number is the depreciation figure. The value of the depreciation is straight line, meaning that it will steadily decrease at the same amount per year. This would amount to $20,000 per year after the $5,000 salvage is taken into account ("Straight Line Depreciation", 2017).
This income statement was calculated by computing the positive and negative impacts on income that I discussed above. Calculating the inflows and outflows have given us an overall cashflow for the project. Currently there are two important points of note: the first is that after- tax figures are the same as the before-tax figures listed above. This is because the values are all negative, and therefore there would be no tax placed. The other noteworthy line is interest. I have denoted this with a '*' to tell myself that it is an optional expenditure. My partner and I could, in theory, pay for the machinery out of pocket and pay $15,750 less over time. At this point I would advise using the option to borrow from the bank, as the percent of interest is quite low and it would be difficult for our company to obtain $105,000 upfront. As far as the income statement is concerned, the $15,750 is not enough to make the investment profitable. Therefore, I would most likely borrow from the bank at 3% interest on the $105,000 loan. 105,000 x .03 would lead to the annual $3,150 expense listed above. From here I will continue on to NPV calculations:
Income statement
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Revenue
25,000
27,000
27,000
28,000
23,000
Cash outflow
13,000
12,000
12,000
12,000
10,000
EBIT
12,000
15,000
15,000
16,000
13,000
Depreciation
20,000
20,000
20,000
20,000
20,000
Interest*
3,150
3,150
3,150
3,150
3,150
Profit before tax
-11,150
-8,150
-8,150
-7,150
-10,150
WEPROMOTE CONTINUING ANALYSIS
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NPV
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Cash flows from Profits
8,850
11,850
11,850
12,850
9,850
Machine cost
105,000
Salvage
5,000
Bank loan
105,000
105,000
Cash Flow
0
8,850
11,850
11,850
12,850
90,150
7% Discount
1
.9346
.8734
.8163
.7629
.7130
PV
8,271
10,350
9,673
9,803
64,276
NPV
-26,178
("Discount Rate", n.d.)
This NPV table was computed by first determining the Cash flows from Profits. This
figure is found by using the profits after tax and adding the depreciation value, as depreciation reduces net income but does not require cash. As such it does not affect the cash listed in the NPV statement, though it did reduce the net income of the income statement I performed previously (Averkamp, n.d.b). I then added the costs and multiplied these values by the discount factor of 7% to come up with my Present Value numbers. Adding these gave me the NPV figure.
The next point I would like to make is that the interest from the loan is not added here. Were it to be included, the NPV would be –39,096. This again shows that while not including the bank interest/not borrowing from the bank would have an impact, it also would not make the project profitable. However, not including 3% interest would be the standard practice for an NPV .
From the above it is clear that this is not a profitable investment and it should not be pursued by myself and my partner. However, there are possibilities that would make this investment profitable. In the above NPV calculations we did not take into account the DTS (depreciation tax shield) . This is because while the figure is used in managerial accounting for
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WEPROMOTE CONTINUING ANALYSIS
capital budgeting, it will not appear on financial statements. As such it was not appropriate to list in the above.
However, it might be important in further analysis. For example, while the machine we are buying is costly it may be more efficient than alternatives. It is possible that I would consider there to be a $5,000 increase in my contribution margin annually because I bought more efficient machinery (Kokemuller, 2016). In this case I would have to add the tax shield rate for the depreciation value. This would give us a value of $6,000 per year (20,000 depreciation x 30%) ("Depreciation Tax Shield", 2017). I could then add $5,000 contribution margin efficiency +$6,000 DTS annually. This would add up to a total of $55,000 undiscounted.
At our current NPV, this would make a considerable amount of difference. Assume next that we have only calculated the revenue assumed from our single client, when other clients may be interested in our services due to the first client's promotional use of it. Perhaps we can add another $5,000 in revenue annually for these clients without making the machine break down more quickly. When included with the aforementioned, this would lead to an additional $16,000 annually, or $80,00 total extra profit.
Depending on factors such as our hurdle rate, our required internal rate of return, this shows that unaccounted for factors in my initial NPV may make the investment profitable (Averkamp, n.d.a). Ultimately, we must factor in other variables in conjunction with our above NPV to determine if there is a way to make this investment feasible. Using the NPV alone it must be decided against, but I would encourage my partner to look at these other possibilities.
WEPROMOTE CONTINUING ANALYSIS
Works Cited
Averkamp, H. (n.d.)a. What is Hurdle Rate? Retrieved May 2, 2018, from https://www.accountingcoach.com/blog/what-is-hurdle-rate
Averkamp, H. (n.d.)b. Depreciation Expense. Retrieved May 2, 2018, from https://www.accountingcoach.com/cash-flow-statement/explanation/7
Borosky, P., & Business Plan. (2017, August 26). Capital Budgeting Example Problem Solved Using NPV, IRR, and Payback Method. Retrieved May 2, 2018, from https://www.youtube.com/watch?v=56H_VtbehPg
Depreciation Tax Shield. (2017, August 20). Retrieved May 2, 2018, from https://www.accountingtools.com/articles/what-is-a-depreciation-tax-shield.html
Discount Rate. (n.d.). Retrieved May 1, 2018, from http://www.financingcp.org/docs/CP3_NPVTable.pdf
Kokemuller, N. (2016, October 26). What Are Things That Could Increase or Decrease the Contribution Margin Ratio? Retrieved May 2, 2018, from http://smallbusiness.chron.com/things-could-increase-decrease-contribution-margin-ratio- 66145.html
Straight line depreciation. (2017, May 15). Retrieved May 1, 2018, from https://www.accountingtools.com/articles/2017/5/15/straight-line-depreciation
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