Capital Budgeting for Equator Ltd

Question: Discuss about the Capital Budgeting for Equator Ltd. Answer: Introduction: Equator Ltd. is looking at expanding its operations into manufacturing tablet computers. The company has two options to consider from, one being Plant A which is highly automated and the other being Plant B which is more labour intensive. The cash inflow and outflow for both the options have been analysed using capital budgeting techniques, the results of which are presented below: Technique Plant A Plant B NPV $24,451,221 $11,352,323 IRR 19% 18% Payback period 3.7 years 3.4 years (Calculations shown in Annexure) Decision Both the options have favourable results where the NPV is positive, IRR is more than the cost of capital and the payback period is within the project period. However, the company should go ahead with Plant A as it has higher NPV and IRR. Even though Plant B has lower payback period, but for mutually exclusive projects, the project with highest NPV followed by IRR is selected. Hence the company should go for Plant A. Assumptions The cost of capital considered here is 13.35% as this the WACC used by the Computer tablet industry and hence is a better discounting factor as it takes into account all the risks associated with this project. The fixed allocation cost has not been considered in the analysis as it is not an incremental cost. The increased working capital is assumed to be recovered at the end of the project life for both the projects. There is risk inherent in a project because no one can accurately predict the future outcomes. It is due to the variability of the future cash flows of the project. Market risk the economic growth rate is assumed to 5.5% for the project and the sales have been projected on the economic growth rate basis. However, if the economic growth rate does not take as projected, the analysis of the investment may go wrong i.e. if the growth rate decreases, the sales will decrease and the NPV will reduce (Drake, NA) Also there is a risk of a change in the inflation rate. An increase in the inflation rate may increase the operating costs, thus making the project less profitable. Project specific risk The management may predict wrong cash flows for the project. If the prediction goes wrong, then the whole investment may go for a toss. Industry specific risk an abrupt change in the industry specific regulations may increase the industry specific risk. Also technological advancement in the industry may increase risks. Like if a better product comes in the market than tablet computers, the market for tablets will decrease, thus causing loss to the company (Dontigney, NA) Company specific risk this risk may arise due to company specific factors like change in the management of the company, any strikes or lock outs by the employees which may disrupt the operations of the company and thus the revenue might be affected. Efficient Market Hypothesis is a proposition that the stock prices in the market perfectly reflect the true value of the firm from the available information. The theory believes that no investor can gain from identifying undervalued stocks using technical and fundamental analysis. Any new information available in the market about the stock is immediately adjusted in the stock price and hence the stocks become accurately priced. Therefore all investors whether uninformed or experts will obtain the same rate of return (Malkiel, 2003). Also the theory believes that if any trader identifies a undervalued or overvalued stock, this will motivate the trader to undertake trading in order to make abnormal profits and in the process the prices of the stock will move towards the its intrinsic value, making the stock price efficient which reflects its fundamental value. Intrinsic value of a share is the present value of cash flows in the form of dividends and the cash flow from the sale of stock . There are three forms of capital market efficiency i.e. weak efficiency, semi strong efficiency, strong form efficiency. Under the weak form efficiency, it is believed the stock prices fully reflect all the past information of the security. Thus an analyst cannot make gains using technical analysis as it is based on past prices. Under semi strong form efficiency, the stock prices fully reflect all public information about the stock. Hence, traders with access to non public information can make abnormal profits. Under strong form of efficiency, the markets are very efficient and quickly react to the new information to adjust stock prices thus making it impossible for any investor to make excess profits. Capital markets are channels through which the idle funds of a potential investor are put into effective use. A company can raise funds through equity or bonds in a capital market. A company generally raises funds in a capital market for long term projects. It is very convenient for the companies to raise funds if the capital markets are efficient because efficient capital markets ensure the funds flow to the highest valued projects. The stock prices at which the stocks would be issued is determined by the market and the market ensures that the stock prices fully reflect the fundamental value of future cash flows. Thus, if the project of Equator Limited promises to maximise the shareholder value, the future value of all cash flows would be incorporated into the stock prices at which the company would raise the new capital. Also efficient markets enable the company to focus on long term projects instead of short term because the funds are easily available from potential investors for high value long term projects (Jones, Netter, NA) We see that tablet computer is a growing industry and hence the outlook for this industry is good. This will help the company in attracting capital easily as the investors would be willing to invest in an industry which has high growth prospects (Dudley, Hubbard, 2004). And moreover since the company is already an established player in the computer market, these will double the ease with which it can raise the funds. Reference Drake, P., (NA), Capital Budgeting and Risk, accessed online on 22nd January, 2017, available at https://educ.jmu.edu/~drakepp/principles/module6/cbrisk Dontigney, E., (NA), What Factors Increase the Riskiness of a Capital Budgeting Project? accessed online on 22nd January, 2017, available at https://yourbusiness.azcentral.com/factors-increase-riskiness-capital-budgeting-project-26421.html Malkiel, B.G., (2003), The Efficient Market Hypothesis and Its Critics, CEPS Working Paper No.91 Jones, S.L, Netter, J.M., (NA), Efficient Capital Markets, accessed online on 23rd January, 2017, available at, https://www.econlib.org/library/Enc1/EfficientCapitalMarkets.html Dudley, W.C., Hubbard, R.G., (2004), How Capital Markets Enhance Economic Performance and Facilitate Job Creation, Global Market Institute, Goldman Sachs