Capital budgeting decisions
Part a – calculation
In the calculations, revenue will be the sum of expected prize revenue and market/other revenues. On the other hand, the expenditure will be the sum of general expenses, base salary, depreciation, and salary bonus. Salary bonus and general expenses are variable costs and because they depend on CL and PL. The salary of the player is $12,250,000. This represents the salary of the player for the entire 5 year period. Therefore, the annual salary of the player will be arrived at by dividing the total salary by the five years.
Thus, the value of the annual salary will be $2,450,000. Further depreciation is estimated through the division of initial investment ($46,000,000) by five years since there is no salvage value. Therefore, annual depreciation is $9,200,000. All the revenues and variable expenses will be assumed to occur annually. The next step will be to calculate the income generated from the project. This will be the difference between revenue and expenditure.
The project generated negative income before cash flow for all the possible eight combinations as can be seen in the attached excel file. The annual cash flow for each combination will be arrived at through the sum of after tax income and depreciation. Depreciation is added back because it does not represent an actual movement of cash. The annual cash flows for each possible combination were positive. CL Final PL 1 had the highest value of annual cash flow ($7,832,000) while CL Group PL 3-4 had the lowest value of annual cash flow ($3,483,200).
After estimating the annual cash flow for each combination, the next step will be to estimate the net present value and internal rate of return of the project. Net present value is the difference between the present values of net cash flow. On the other hand, the internal rate of return is the minimum discount rate that is required to equate the present value of cash inflows to the present value of cash outflows. The discount rate that will be used in the calculations is 18%. That is, the weighted average cost of capital. The tables presented below show a summary of the results for the net present value and internal rate of return.
Internal rate of return.
Net present value.
Part b – discussion
The results presented in the table above shows that the net present value of the project for all the eight possible combinations were negative. This implies that the present value of cash outflow exceeded the present value of cash inflows. CL Final PL 1 had the highest net present value (-$21, 507,997) while CL Group PL 3-4 had the lowest net present value (-$35,107, 438). The negative net present values indicate that the company will incur net losses if they pursue the project because payments exceed the revenue that the company will generate. Thus, based on this criterion, then the project should be rejected. It is worth mentioning that the net present value is quite subjective. It highly depends on the value of the discount rate used. High discount rates can result in low or negative present value.
The results above also indicate that the values of internal rate of return for all the possible combinations are negative. Further, CL Final PL 1 had the highest internal rate of return (-5.14%) while CL Group PL 3-4 had the lowest value of internal rate of return (-25.56%). The negative values indicate that the project is likely to lose money that is equivalent to the values of internal rate of return that are estimated above. When selecting mutually exclusive projects, investors often prefer projects that have high values of internal rate of return (McLaney and Atrill 189). Besides, most companies often have a predetermined internal rate of return that can be used for benchmarking (Deegan 241).
Thus, if the estimated rate is lower than the predetermined rate, then the project will be rejected. On the other hand, if the estimated rate is higher than the predetermined rate, then the project will be rejected. In some cases, a company often compares the estimated internal rate of return with the discount rate. In this case a project is selected if the estimated rate is higher than the discount rate. In this case, the internal rate of return for the project is lower than the discount rate (Brigham and Ehrhardt 371).
Therefore, based on this criterion, the project should not be pursued. It is worth mentioning that the eight combinations give a sensitivity analysis of the project. They represent, best, moderate and worst case scenarios. The result shows that the company will make losses in all these scenarios. The company will not be able to recover their investments. Therefore, the company should not purchase the asset.
Ratio analysis for mining industry
The success of a business requires effective planning and financial management. Ratio analysis helps various stakeholders to make informed decisions because it breaks down the data into various components for a better understanding of the financial results and trend of the company. Ratio analysis will be carried out for three mining companies over a period of 4 years, that is, between 2012 and 2015. The three companies are Glencore PLC, Anglo American PLC, and BHP Billiton Ltd.
Du Pont analysis
Based on the Du Pont technique, the return on equity can be broken down into three components. These are net profit margin, total asset turnover, and equity multiplier. There was a general decline in return on equity for the three companies. BHP Billiton had the highest value of the ratio while Anglo American had the lowest value. In the case of Glencore PLC and Anglo American PLC, equity multiplier and asset turnover contributed significantly to the value of ROE. However, in the case of BHP Billiton, the high value of ROE can be explained by net margin. This shows that the shareholders are earning a negative return in the mining industry. This can be an indication that equity is being consumed by the negative returns (Weygandt, Kieso and Kimmel 314).
Liquidity
Liquidity ratios show the ability of an organization to maintain positive cash flow while satisfying immediate obligations, that is, the availability and adequacy of current assets to pay current obligations. The liquidity ratio for Glencore PLC deteriorated with a slight improvement in 2013 while for Anglo American improved during the four year period with a slight drop in 2013. The ratios for BHP Billiton grew during the period. Further, Anglo American PLC had the highest liquidity level followed by Glencore PLC while BHP Billiton had the lowest ratios. This implies that Anglo American PLC is more capable of paying immediate obligations using current and quick assets than the other companies.
Profitability
Profitability ratios give an indication of the earning ability of the Group. The ratios measure the effectiveness of a company in meeting the profit objectives, both in the long and short run. The profitability of the three companies deteriorated. Glencore had negative profits in 2013 and 2014 while Anglo American PLC had negative profit in all the years. The profitability ratios for BHP Billiton fluctuated with a steep decline in 2015. Besides, the company had the highest level of profitability followed by Glencore PLC. It can be observed that the profitability of companies in the mining industry is dwindling. The companies are struggling to generate positive profits.
Asset utilization
This category of ratios focuses on the internal operations of the company and the level of activity. That is, how well the Group manages resources to generate sales. There was a general decline in the asset utilization ratios for the three companies. In the three companies, inventory turnover, payable turnover and fixed asset turnover dropped. Further, the efficiency ratios for Glencore PLC were slightly higher than those of the other companies. This can be an indication that the mining industry is facing problems with efficiency in managing internal operations.
Debt utilization
A company’s gearing is explained by the amount of debt financing it holds. The ratios are vital since they show the extent of exposure of equity financing. A commonly used ratio is the debt to equity ratio. There was a general increase in the debt to equity ratio for Glencore PLC and Anglo American PLC. This shows that the amount of debt in their capital structure grew. The debt to equity ratio for BHP Billiton was fairly stable. It ranged between 0.38 and 0.43. This indicates that the company manages and controls the debt level in the organization. On average, Glencore PLC had the highest debt to equity ratio, while BHP Billion has the lowest.
Interest coverage ratio for the three companies fluctuated during the period. The values of this ratio for Glencore PLC and BHP Billiton dropped in 2013 and 2015. This can be attributed to a combination of increase in debt and a decline in operating income. The interest coverage ratio for Anglo American deteriorated during the period with a slight increase in 2013. BHP Billiton had the highest value of interest coverage ratios. This ratio shows that both Glencore PLC and Anglo American PLC could be facing solvency problems and their going concern is at risk (Fridson and Alvarez 246).
In summary, the financial standing for the three companies is dwindling and unstable. From a financial point of view, the companies are struggling in all aspects. This is a replica of the problems faced in the mining industry. The industry is facing high levels of debt coupled with low demand and declining prices (The Financial Times Limited 1). Some companies have filed for bankruptcy due to an inability to continue operation.
Works Cited
Brigham, Eugene and Michael Ehrhardt. Financial Management Theory and Practice, Boston: South-Western Cengage Learning, 2009. Print.
Deegan, Craig. Financial Accounting Theory, London: McGraw-Hill, 2009. Print.
Fridson, Martin, and Fernando Alvarez. Financial Statement Analysis: A Practitioner’s Guide, New York: John Wiley & Sons, 2011. Print.
McLaney, Evans, and Peter Atrill. Financial Accounting for Decision Makers, London: Financial Times/Prentice Hall, 2008. Print.
The Financial Times Limited. Mining. 2016. Web.
Weygandt, Jerry, Donald Kieso, and Paul Kimmel. Financial Accounting, London: John Wiley & Sons Ltd, 2009. Print.