FINC2011 Assessment

Cicero Mines Investment Analysis
Part 1: Project Evaluation
When making capital budgeting decisions, there are various techniques that can be utilised. Ross et al. (2008) describes that the predominant capital budgeting methods used as being the Net Present value (NPV) method, the Internal Rate of Return (IRR) method, the Payback method, and the Accounting Rate of Return (ARR) method. Conversely, Brealey, Myers and Allen (2011) proposes that the NPV and IRR methods are considered prestige compared to the ARR and the Payback Methods, as they take into account the time value of money. Thus, the following project evaluation will focus on using the NPV and IRR methods.
NPV Method:
The Net Present Value method discounts future cash flows of a project in attempt to discover the value of a project in present terms, considering the time value of money. Multiplying the tax rate by the incremental taxable profit, where incremental taxable profit is found by misusing expenses and depreciation from annual revenues, provides the NPV.
NPV of Machine A:
The tax paid is calculated as the tax rate x the incremental taxable profit as follows:
Year
1-5
6
Annual Revenues
300,000
300,000
Salvage Value

10,000
Less Annual Depreciation
(35,000)
(35,000)
Less Annual Operating expenses
(152,000)
(152,000)
Incremental Taxable Profit
113,000
123,000
Annual Tax at 30%
33,900
36,900
Net Profit after Tax
79,100
86,100

Cash flows for the following years are calculated as follows:
Year
0
1-5
6
Machine Cost
(200,000)

Installation cost
(10,000)

Working Capital
(80,000)

80,000
Incremental Taxable Profit

113,000
123,000
Salvage Value

10,000
Plus Depreciation

35,000
35,000
Free Cash Flow before Tax
(290,000)
148,000
158,000
Less Tax

33,900
36,900
Free Cash Flow
(290,000)
114,100
121,100
Analysis and explanation:
Initially, the machine and installation costs and working capital symbolise the negative cash flows in

References: Bowman, R. G., and Bush, S. R., 2006, Using Comparable Companies to Estimate the Betas of Private Companies, Journal of Applied Finance 16(2), 71-81. Brealey, R. A., Myers, S. C and Allen, F. 2011, Principles of Corporate Finance, 10th Ed., McGraw Hill Irwin, New York. Brigham, E and Ehrhardt, M, 1998, Financial management: Theory and Practice, Harcourt College Publishers. Forbes, 2012, Ratios and Returns, Forbes, Sydney, viewed 21 October 2012 http://finapps.forbes.com/finapps/jsp/finance/compinfo/Ratios.jsp?tkr=bhp Megginson, William L, 2005, Introduction to Corporate Finance, South Western College Pub, Cincinnati. RTCrawford’s Weblog, 2008, BHP Billiton Ltd, Sydney, viewed 22 October 2012 http://rcrawford.wordpress.com/2008/05/25/bhp-billiton-ltd-bhp-buy-sell-hold-may-24-2008/ Ross, S., Westerfield, R. and Jordan, B. 2008, Corporate Finance Fundamentals, 8th ed., McGraw Hill, New York. Reserve Bank of Australia (RBA), 2012, Capital Market Yields – Government Bonds – Monthly, RBA, Sydney, viewed 21 October 2012 http://www.rba.gov.au/statistics/tables/#govt_finance Yahoo Finance, 2012, BHP Billiton - Key Statistics, Yahoo, California, viewed 22 October 2012 http://au.finance.yahoo.com