This memo is being prepared to analyze the acceptability of the new production facility for company at different hurdle rates and the implications of accepting the same on company earnings, cash flow and contribution to return on equity. This will strengthen the justification why this project was chosen as against other options. This project has positive net present value (NPV) at different rates of 10, 15% and 18%, which makes it acceptable.
Positive NPV in finance theory means that at cost of capital, the present values of cash outflow and outflows will be beneficial to the company as it will increase the company cash position and earnings (Brigham and Houston, 2002). To illustrate if the NPV of $1,291,659. 16, if is assumed to be most accurate value based on cost of capital at 10%, then said amount is effectively an increase in cash under the balance sheet of the same amount and increase in income under the income statement. See Appendix A.
Increasing cash position improves as well liquidity position of the company. Liquidity position is measured by quick ratio and current ratio. In both cases, increasing cash, which is part of quick assets or current assets, by certain amounts without corresponding increase in current liability will definitely increase the said liquidity ratios and could strengthen the company’s position against possible bankruptcy. It must be noted that computations in Appendix A treated as cash outflows the following: rental or lease expense of $1.
5 million a year, other expenses of $100,000 per year as cash outflows, project cost of $4 million and the corresponding taxes, while the cash inflows include the yearly revenues and the depreciation which was added back because it does not entail a cash outflow when deducted as part of operating expenses for tax purposes. In effect, the depreciation provided a tax shield for the project. In terms of its impact of return to equity (ROE), the same will also increase the said rate even assuming that the $4,000,000 initial cash outflow at year 0 was financed by equity.
If is assumed that company has a present equity of $100 million and the project cost of $4,000,000 was financed through equity or additional investment from owners, its 2003 income statement at $ 29. 4 million, assuming the same level of income, will be attained when the production facility is implemented, would increase to $30. 69 million. If the same amount is divided by new equity of $104 million, this could increase the ROE to 29. 51% from 29. 4% before the project.
It is therefore recommended that the project of new production facility should be accepted by the company because the project has positive NPV and its MIRR of 18% is greater than cost of capital of 10%. See Appendix A. Recommendation is further based on increase in the cash position of the company, increase net earnings and increased return on equity that could further attract investors by possibly increasing the stock price of the company. Appendix A- See Excel File References: Brigham and Houston (2002) Introduction to Financial Management, Thomson-South Western, USA. Case study- given with income statement