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Reliable electric case study Essay

Question A and B

Capital Expenditure – the capital costs incurred for the project should be considered because they are additional expenditure arising from the capital project at hand.  Therefore they are justifiable in this financial examination.

Research and Development Costs – these costs have already been incurred in 2002 and therefore they cannot be altered by the decision taken of accepting or not accepting the industrial electric motor project.  Such expenditure is commonly known as sunk costs and should not be included in the project evaluation because they are irrelevant for such decision.

Working Capital – the working capital invested in the project, which solely comprises inventory should be considered in the project feasibility evaluation the same as the capital expenditure incurred.  The cash outflow of 4,000 in 2003 is therefore justified in table 6.7 of the case presented.

Revenue – the sales revenue derived from motor vehicles should be included in this evaluation provided they are directly related to the industrial electric motor project.  This implies that such sales revenue should be generated from this project.

Operating Costs: direct and indirect expenditure by their nature are costs that are related to the units produced.  Therefore since such costs are the result of the

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industrial electric motor project, they should be considered in its financial examination.

Overhead: if these marketing and administrative costs will be originated from the project they should be considered. However, they should be evaluated carefully because some of these expenditures may be sunk costs and will not be affected by the decision.  For instance if an administration manager at a salary of £45,000 is already employed in the organisation, and no assistant will be employed once the project commences operating.  In such a case, this cost should be excluded from the capital project appraisal.

Depreciation – depreciation is a non-cash expense and does not involve outflow of cash and cash equivalents.  Thus certain capital expenditure appraisal methods, like the net present value technique, which is the one adopted by Reliable Electric, do not account for such expenditure, because they focus solely on cash inflows and outflows.  Therefore is should be removed from the financial analysis.

Interest – if the interest expenditure was the result of debt commitments taken to finance the project in the long term, such incremental costs would have been justified to be included as part of the cash outflow.  However, the once charged in table 6.7 of this case are charged as an opportunity cost of the money foregone.  Such economic cost ought to be included in the discount rate computation, which is considered further below in the project proposal examined.  Therefore the interest expenditure has to be removed from the capital project expenditure appraisal.

Income – the income figure includes research and development, depreciation and interest ought to be excluded from its computation.  The other items are acceptable provided they meet the conditions and specifications already set.  If the aforesaid unwarranted costs are removed, the income figure would be automatically arrived at the correct figure.  Therefore the gist of providing a correct and reliable capital project appraisal mainly rests on the elements previously mentioned.

Tax – the cash outflow arising from the tax liability on the income generated from the project should be considered when assessing the capital project feasibility.  However, the loss carried forward in 2003 is only justified if the corporation tax legislation allows the organisation to carry forward such loss and deduct it from the taxable income. Such act is forbidden in a number of countries and is probably not the case.  Therefore the loss carried forward in table 6.7 should be removed and the whole tax liability ought to be taken into account in 2005.

Net Cash Flow – the same treatment that was adapted to the income figure applies to the net cash flow, since it is the result of a calculation of previous revenues and expenditures.  In this respect, the research and development costs, depreciation, interest and the tax loss carried forward should not be considered for this capital project.  As already stated is such factors are removed in the computation, the net cash flow would automatically be correct, since it is a derivative of such elements.

Net Present Value – the same principle utilized in the net cash flow is adopted here and the same costs that ought to be removed in the previous element should be omitted from this figure too.  An additional comment that is necessary is such facet is concerning the discount rate.  The discount rate, which is the summation of the inflation rate, risk free component, general risk premium and property specific risk premium, represent the value arising from the timing of cash flows to cater for the additional risks and losses mentioned above.  The net present value method, by abiding with such principle includes the discount rate.  Since it includes the risk free component, which is the opportunity cost arising from the investment that comprises the opportunity cost that is normally the loss of money arising from the investment.  For example by investing in the project, the investor is losing the chance to invest in order profitable business opportunities.  Thus the interest rate opportunity cost of 15% previously has to be taken into account in the discount rate figure, if it has not been the case.  This information is not provided in the case study and therefore we will presume that the discount rate figure includes such risk element for the completion of the next question.

Question C

Net Present Value Calculation Table:

Details
2003

£
2004

£
2005

£
2006-2013

£
Capital Expenditure
(10,400)

Working Capital
(2,000)

Revenue

8,000
16,000
40,000
Operating Costs

(4,000)
(8,000)
(20,000)
Overhead

(800)
(1,600)
(4,000)
Income
(12,400)
3,200
6,400
16,000
Taxation (see note 1)
0
(756)
(1,876)
(5,236)
Net Cash Flow
(12,400)
2,444
4,524
10,764
Net Present Value (see note 2)

+29,671

Note 1:

Taxable Income Determination:

Details
2004

£
2005

£
2006-2013

£
Income as per table above

3,200

6,400

16,000
Depreciation
(1,040)
(1,040)
(1,040)
Taxable Income
2,160
5,360
14,960

Notes:

·          The depreciation expense was deducted from the income in order to determine the taxable income because corporation tax legislations allow capital allowances representing loss in value of tangible fixed assets to be deducted from the taxable income.  The corporation tax rate of 35% will now be applied to the figures determined above.

·   The opportunity cost arising from the interest foregone was not included because this is a non-allowable expense under tax legislation.

·   For simplicity and clarity the 2003 figures were not included because they are outside the scope of taxation since no income will be generated in such year.

Taxable Income in 2004: £2,160 x 35% = £756

Taxable Income in 2005: £5,360 x 35% = £1,876

Taxable Income from 2006 to 2013: £14,960 x 35% = £5,236 per annum

Note 2:

Applicability of Discount Rate to Determine Net Present Value

Year
Net Cash Flow

£
Discount Factor

£
Present Value

£
2003
(12,400)
1.0000
(12,400)
2004
2,444
0.86957
2,125
2005
4,524
0.75614
3,421
2006
10,764
0.65752
7,078
2007
10,764
0.57175
6,154
2008
10,764
0.49718
5,352
2009
10,764
0.43233
4,654
2010
10,764
0.37594
4,047
2011
10,764
0.32690
3,519
2012
10,764
0.28426
3,060
2013
10,764
0.24718
2,661
Net Present Value
29,671

References:

Brockington B. R. (1996). Financial Management. Sixth Edition. London: DP Publications.

Drury C. (1996). Management and Cost Accounting. Fourth Edition. London: International Thomson Business Press.

Lucey T. (2003). Management Accounting. Fifth Edition. Great Britain: Biddles Limited.

Pike R.; Neale B. (1999). Corporate Finance and Investment. Third Edition. England: Pearson Education Limited.

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