Among the various decisions that finance focuses on to maximize wealth of the shareholders of the firm, capital investment decisions are very important. It focuses on where and how the funds of a firm will be invested to earn a return equal to or higher than its required rate of return. If these decisions are made properly, the firm is sure to achieve its goal. However, if decisions are inaccurately made, then the firm will have to face uncertainty to attain its goals. That is why a number of techniques and procedures are used to ensure the accuracy of capital investment decisions, as we studied in our course. Nevertheless, the real world is very much dynamic and capital investment decisions here are far more complex than we studied in the courses. As a result, the process of capital investment decision in real world can be very much different from the ones we studied. So, we tried to find out how a finance manager in Bangladesh makes capital investment decisions and what factors and techniques he considers in the decision making process. For this, as our course teacher recommended, we have studied the ‘Annodin Group of Publications Ltd.’ and try to determine how capital investment decisions differ in practice than books.
Description of the Firm
Annodin Group of Publications Ltd is a private limited company formed in 1985. It originally focused on publishing business. Nevertheless, currently it has a diversified business area with the following subsidiaries of the firm-
- Annodin newsgroup
- Annodin media group
Overview of the Project
We have studied one of the major capital investment projects undertaken by the company, Annoprokash. It was undertaken at year 1995 with the objective to enter literature publications business. It was estimated then that the project will continue perpetually. After studying the project, we found the following information about capital investment decision
To initiate the project, the firm needed to purchase equipments, purchase space for warehouse, rent offices and meet other preliminary expenses. For this, primarily the company determined that it will require a 2 million Tk. investment to start the project, which would be financed with equity. Since this is a highly competitive business, it will take at least four years to determine whether the project is a success or failure. If it is a success, then production will be increased and an additional investment of 1 million will be required. However, if the project is a failure, then production will be reduced and 0.5 million Tk. can be withdrawn and put into other projects. If the project is a success, then the firm will go on expansion to gain competitive advantage as soon as possible, but not before 2 years immediately after success. For expansion, the firm would require 6 million of investment. The project will have an unlimited life regardless of success or failure. In addition, the recovery from investment on machines and equipments are negligible.
In actual, the investment turned out to be a success at 1999 and later at 2001, expansion occurred. Currently the project is a high growth, highly profitable one with a ranking of no. 1 in the business.
Net working capital:
According to the data we have collected, the estimated investment in net working capital was approximately 0.5 million in the initial year. In the later years, an additional amount was needed each year that was approximately 50% of expected sales growth and 30% of additional investments on average.
The main components of net working capital were inventory, cash buffer, printing materials, printing plates etc.
Operating Cash Flows:
Revenue: the main source of revenue was from sell of publications. The firm expected that in the first year the project will reach its break even . After that, revenue will grow @ 2% each year. Later, when the company faced a growth in 1999, its revenues were growing @ 10%. Before expansion in 2001, growth rate of revenues was approximately 15%. Till then, revenues have grown at an increasing rate and currently the growth rate of sales is more than 20%.
Costs: costs have increased at the general rate of non-food inflation rate over the year. In addition, increased operations have also brought in additional costs for the project. Therefore, since 1999, costs have increased @ 10-12% each year. Before that period, costs were increasing @ 6-8% on average.
Role of depreciation: the firm has quite a large amount invested in fixed assets like machineries and equipments. As a result, it is having a substantial tax benefit from depreciation. Last year, the amount of depreciation was approximately 0.3 million.
In evaluating the project, the firm had to consider opportunity cost issue. The major ones in this respect were-
Warehouse and showroom:
the firm had to decide whether to rent warehouse and showroom or acquire them through purchase. On this issue, the firm constructed own warehouse and showrooms, as the opportunity cost was lower in that case. These showrooms and warehouse also facilitates the other subsidiaries of the firm, thus creating synergy.
the firm had to purchase equipments, which it could have also obtained through leasing. However, through purchasing, it can not only use it for the project, but also earn additional revenues by leasing or renting.
Sunk Cost Issue:
In capital investment decision, the firm does not consider any sunk cost.
Projected Income Statement:
Based on our studies, the projected income statement of annoprokash can be shown as following-
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Determining Costs of Capital
As we collected information from ‘Annodin Group Of Publications Ltd.’, we found that the firm uses a target debt-equity ratio of 40:60 for all its projects. Therefore, when any project is financed, they try to maintain the target debt to equity ratio, irrespective of whether it is an expansion requirement or working capital requirement. In addition, the firm is subject to corporate taxes. These factors affect the cost of capital of the firm. Moreover, since the firm tries to maintain a similar composition of equity and debt in all its projects, the firm’s cost of capital can be a better estimate of the project’s cost of capital.
Cost of Equity:
Since the shareholders (4) of the company receive their earnings after corporate and personal taxes, they consider the required rate after taxes. As we studied, we found that, the cost of levered equity after corporate taxes for the firm is 20%.
Cost of Debt:
Most of the debt financing in the firm represent mid and long term bank loans. Thus, the cost of debt is very much equal to the bank’s interest rate on loans. However, since these debt financing provides tax benefit, the true cost of debt would be after taxes. Currently the cost of debt before taxes for the firm is 15%
Impact of Tax:
In determining the cost of capital for the firm, we must consider the impact of tax since return for both shareholders and lenders depend on tax rate. Thus in determining the weighted average cost of capital, we have to count for taxes. Currently, the firm is in 30% tax bracket and its shareholders are in 20% tax bracket (assumed).
Weighted Average Cost of Capital (WACC):
Based on the information collected we calculate the WACC for the investment as follows.
Project Evaluation Techniques
As with any business, selecting the right place to invest is the key to success. And for that, investment projects must be evaluated with appropriate evaluation techniques. Though we learned about a number of financial techniques for project evaluation, their application in the real world can be only known from business organizations. Keeping this view in mind, we studied the firm and found the following about its investment evaluation techniques.
The firm often uses the NPV technique to evaluate project, using its overall cost of capital as discount rate. According to them, the most beneficial use of this analysis is evaluating an investment’s returns in terms of Tk. amount, which gives them a basis for comparing investment requiring different volume of investments.
Since the firm often has to finance investment projects for expansion, or growth etc reasons, the cash flow stream of its investment projects are often in a non-conventional pattern. So, using IRR in such projects will lead to multiple IRR problems. For this reasons, the firm does not use this technique.
The firm’s area of operation is very much affected by seasonal fluctuations. As a reason, the firm often faces capital inadequacy during peak seasons. As a result, it has to ration its capital and that is where Profitability Index comes very useful to the firm
Although this is not a DCF technique, the firm uses this method widely because of its simplicity and ability to give a quick idea about investment recovery. Usually the firm expects to recover initial investment within 3-8 years depending on the nature of business and volume of investment.
Techniques for contingency planning
The firm extensively uses sensitivity analysis to determine project’s NPV’s degree of dependence on specific variables. The firm mainly uses sensitivity analysis based on sales volume, production costs and variation in product mix.
The firm does not use scenario analysis due to complexity involved in such analysis.
Break Even Analysis:
Cash Break Even:
Cash break even measures the sales level that results in a zero operating cash flow. The project that just breaks even on cash flow basis can cover its own fixed operating costs. The cash break even of this project for each job is 500 units
Other break even:
The firm uses accounting and financial break even as well. But the other break even points differ for each job as job category changes
The firm tries to reach cash break even at year 1 and then head for attaining accounting and financial break even as soon as possible, and then to higher earnings.
Use Of Operating Leverage:
Operating leverage is the degree to which a project or firm is committed to fixed production cost. The project use operating leverage through investing in warehouse, showrooms, machines etc. The high operating leverage of the project has significant magnifying impact on earnings.
The firm faces forecasting risks in capital investment decisions in the following matters-
- Publishing books of new writers: This risk is handled through changing product mix.
- Market situation: This represents the systematic risk and cannot be reduced.
- Along with these factors, the higher degree of operating leverage in the project also creates higher forecasting risks because the break even level increases with the rise in degree of operating leverage.
It will take four years to determine whether the project is failure or success and only then the options will be considered. The firm considered the following options-
Option to Expand:
The firm will increase production if it’s a success. Once production expanded, if further growth is observed, then another larger expansion will take place.
Option to abandon:
Most of the investment was in fixed assets that were highly specialized for that business only. So the firm decided that if the project is a failure, it will not be abandoned, rather production will be reduced and its resources will be diversified to other segments of the firm.
The firm also considered timing options in deciding when to expand, and this option was executed in the expansion of 2001
Financial Side Effects
The project has experienced the following side effects-
- The other subsidiaries of the firm created synergy and thus have contributed to increased profitability of the project.
- By using debts for financing the project, the firm enjoyed positive financing side effects in the project.
- Since the firm has a long term relationship with many other businesses, it enjoys a lot of flexibility in decision making regarding its capital investment decisions.
Manager’s experience plays a vital role in capital investment decisions. In annoprokash, manager’s experience had a significant impact on the following fields-
- Determination of financing sources
- Demand assessment
- Internal control
- Management of working capital, especially inventory
The Capital Investment Decision (CID) is the most significant and crucial decision of a firm. The manager’s duty is to maximize the value of the firm by investing in long term assets. The value will be maximized if the capital investment decision is correctly taken, otherwise the firm will lose it. To take a correct capital investment decision, the firm uses various types of techniques. As the real world is complex and dynamic, so the techniques used for CID in the context of Bangladesh are little bit different from what we studied. The different firms use different techniques depending on the nature of cash flow, nature of business and complexity of the situations. Along with these, the firm considers various issues such as sunk cost, opportunity cost, allocated cost, financing expense etc. related to CID. Firm also takes into account various strategic issues such as Break Even Analysis, scenario analysis, sensitivity analysis, operating leverage, options etc. Whatever the manager does, he does it to manage the project successfully and we have seen these in our study on “Annodin Group of Publications Ltd.’. And from our study, we’ve found that, in Bangladesh, a Finance Manager takes capital investment decisions based on the investment techniques as well as the real world factors.