Inflows Outflowsover Specified Time Horizon Essay

Question:

Discuss About The Inflows Outflowsover Specified Time Horizon.

Answer:

Introduction

Branson Ltd is a public listed company in Melbourne. They operate in the tours industry. Currently, the company’s hot air balloons used for their tours have retired. As a result, the company is now faced with the decision as to whether to replace their current balloons with a larger or smaller model. Furthermore, they are also considering the option of selling the business within 4 years should they proceed with either of the above models.

The purpose of this report is to determine whether the company should replace its balloons with either a large or a small model. Furthermore, it determines whether the company should sell the business within the next 4 years, using either model.

To perform the above analysis, quantitative techniques including the Net present Value (NPV) and Internal Rate of Return (IRR) were compared and analyzed for both models.

The report is divided into five sections. Section one discussesBranson’s discount rate. Section two, discusses theafter tax cash flows, NPV and IRR under all scenarios. Lastly, section three recommends the best model the company should adopt based on analysis of the quantitative methods.

Discount Rate

In this section, we calculate the appropriate discount for Branson based on their capital structure, cost of debt and cost of equity.

A company’s discount rate is their minimum rate of return it should earn on an investment. In most cases, a company’s cost of capital is used as a good starting point for the company’s discount rate.

The company’s cost of capital is calculated as the average cost of equity and after tax cost of debt.

  1. Cost of Equity

The cost of equity for Branson Ltd can be determined using the Capital Asset Pricing Modelbelow.

Re = rf + Beta (rm –rf)

Where rf = Risk free rate, (rm –rf)= Risk premium

The company has provided information for the last 20 years on their historical returns, market portfolio returns and risk free rates.

Thus, to calculate the Beta for Branson,linear regression was done on the returns. This gave a beta of 1.56. The average market risk premium was determined as 4.29% and the average risk free rate was 4.84% over the past 20 years.

Based on the above figures, using CAPM, the cost of equity for Branson was determined as 11.54%.

  1. Cost of Debt

Based on the company’s current debenture and the current market yields, the cost of debt for Branson Ltd is 12%.

  1. Weight of Debt and Equity

The company has stated that they have a debt to equity ratio of 1:5. Furthermore, they have no intentions to change their capital structure in the near future. Thus, this information can be used to determine the optimum weights of debt and equity, which are given as 16.67% and 83.33% respectively.

  1. Weighted Average Cost of Capital

The company’s cost of capital can be determined using the relationship below

WACC =Weight Debt * cost of debt *(1 – T) + Weight equity *cost of equity

Where T is the corporate tax

Thus, Branson Ltd will require a minimum return of 11.02% to be able to accept any project.

After Tax Cash Flows

Assuming a time horizon of 8 years, we can project the after tax cash flows, the NPV and IRR for both the large and small balloonmodels, under the option of not selling and selling within four years. (Note for the selling option the assumption is the company will sell the business in year 4.)

The table below is a summary of results for each scenario.

Year

0

1

2

3

4

5

6

7

8

Large Balloon (no selling)

(850,000)

146,750

196,750

196,750

196,750

135,500

135,500

135,500

220,500

Large Balloon (selling)

(850,000)

146,750

196,750

196,750

526,750

Small Balloon (no selling)

(530,000)

99,750

129,750

129,750

129,750

103,500

103,500

103,500

154,500

Small Balloon (selling)

(530,000)

99,750

129,750

129,750

215,750

Table 1: After Tax Cash flow

Scenario

NPV

IRR

Small Balloon (no selling)

78,820

15.00%

Large Balloon (no selling)

28,675

11.96%

Large Balloon (selling)

-67,598

7.91%

Small Balloon (selling)

-97,997

2.97%

Table 2: NPV and IRR

Large Balloons and Company does not sell

Applying the discount rate of 11.02%, the NPV is calculated as $28,675. Since NPV is positive, Branson should accept the project. Furthermore, the IRR is 11.96% which is greater than 10.41%, again suggesting the business will be profitable under this option.

Small Balloons and Company does not sell

For the small balloon model, applying the discount rate of 11.02%, the NPV is calculated as $89,541. Since NPV is positive, Branson should accept the project. Furthermore, the IRR is 15% which is greater than 10.41%, again suggesting the business will be profitable under this option

Large Balloons and Company Sells Business in Year 4

Under the option of selling the business in year 4, applying the discount rate of 11.02%, the NPV is calculated as $(67,598). Since NPV is negative, Branson should not sell the business in 4 years. Furthermore, the IRR (7.91%) is lower than 10.41% suggesting that selling is not a good option.

Small Balloons and Company Sells Business in Year 4

Under the option of selling, applying the discount rate of 11.02%, the NPV is calculated as $(97,997). Since NPV is negative, Branson should not sell the business in 4 years. Furthermore, the IRR is lower than 11.02% suggesting that selling is not a good option.

Conclusion

Based on the above NPV and IRR analysis, Branson should proceed not to sell the business within 4 years and operate the business for at least 8 years. This is because the NPV was less than zero under the selling option and positive under the 8 year option.

Secondly, production of the smaller balloon model had a higher NPV than the larger balloons. Therefore, Branson Ltd should proceed to produce smaller balloons as it is more profitable than large balloons in the long term.

In conclusion, it is recommended that Branson should go with the small balloon model for the next 8 years.

References

Accounting Explained. (2017). Capital Budgeting. Retrieved September 2017, from Accounting Explained:

Tucker, J. (2009). How to set the hurdle rate for capital investments. Retrieved from

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