Finance for Managers

Table of Contents

Introduction: 4

Task 1: Capital Structure and Payout Policy Analysis. 4

Quantitative analysis: 4

Qualitative analysis: 7

Task 2: Capital Budgeting Task. 7

1. Explanation of the chosen methods: 8

2. Inputs and assumptions made: 9

3. Summary of findings: 10

4. Sensitivity analysis: 11

5. Recommendations: 11

6. Further or follow-up matters: 11

Conclusion: 11

References: 13

Appendices: 15

Introduction:

The current assignment intends to provide an in-depth analysis of the capital structure payout policy of Cochlear Limited. For this analysis, the aspects considered include the capital structure policy of the organisation based on current and historical data and its theoretical evaluation. The second section of the assignment consists of preparing a memo for the CEO of OnePack Limited, which is operating in the packaged food industry. The organisation is planning to undertake a decision regarding the development of a commercial sale plant. In order to assist in the decision-making process, different capital budgeting techniques have been used that mainly comprise of net present value, internal rate of return, payback period and profitability index. For better evaluation of the concerned project, sensitivity analysis has been used as well based on which final recommendation has been provided to the CEO of OnePack Limited.

Task 1: Capital Structure and Payout Policy Analysis

For analysing the capital structure and payout policy of Cochlear Limited, the data of the past three years have been taken into consideration. Moreover, certain ratios have been used for evaluating the policies and they primarily include debt ratio, equity ratio, debt to equity ratio and dividend payout ratio. The results of these ratios would be evaluated and they would be supported by adequate theoretical justifications in the following sections.

Quantitative analysis:

As discussed above, there are four ratios used for analysing the capital structure and payout policies of Cochlear Limited and they are evaluated briefly as follows:

Table 1: Capital structure and payout ratios of Cochlear Limited for the years 2016-2018

(Source: Cochlear.com 2019)

Figure 1: Capital structure and payout ratios of Cochlear Limited for the years 2016-2018

(Source: Cochlear.com 2019)

Debt ratio denotes the proportion of assets of an organisation, which is funded by loans and other borrowings (Robb and Robinson 2014). In case of Cochlear Limited, it could be seen that the debt ratio has fallen slightly from 0.53 in 2016 to 0.52 in 2017 and the decline is further inherent to 0.47 in 2018. The lowering ratio implies sound and stable business having the potential of longevity for Cochlear Limited. Moreover, the ratio below 0.5 is considered as less risky, as the organisation has above twice assets compared to liabilities.

On the other hand, equity ratio denotes the proportion of assets of an organisation, which is funded by the shareholders and the investors (Graham, Leary and Roberts 2015). Contrary to debt ratio, equity ratio of Cochlear Limited is observed to increase from 0.47 in 2016 to 0.48 in 2018 and further increase could be observed to 0.53 in 2018. This clearly implies that the organisation has focused on raising more funds through debt for minimising its solvency risk.

Debt to equity ratio denotes the proportion of company financing, which is coming from the investors and the creditors. This ratio is observed to decline from 1.13 in 2016 to 0.89 in 2018 implying stable financial position for Cochlear Limited. In addition, this ratio implies that the investors have more stakes in Cochlear Limited than the creditors and thus, the organisation is perceived as less risky from the perspectives of both the creditors and the investors.

Dividend payout ratio signifies the proportion of net profit distributed to the shareholders as dividends during the period (Faccio and Xu 2015). This ratio has increased slightly from 69.49% in 2016 to 70.26% in 2018, which implies that the organisation has focused more on paying dividends to its shareholders.

Based on the above quantitative analysis, improvements could be observed in the capital structure and dividend payout policy of Cochlear Limited from 2016 to 2018.

Qualitative analysis:

According to the Modigliani and Miller theorem of capital structure, there is no importance of debt in the capital structure of an organisation. This statement is based on two assumptions, which are provided as follows:

• 
  

  There is no impact of financing structure on cash flows generated by an organisation.

  
  


• 
  

  Financial markets are perfect because there is no trading cost (Öztekin 2015).

  
  

However, in reality, if there is absence of any financial leverage, the weighted average cost of capital would remain the same. Moreover, if the managers of Cochlear Limited choose an inappropriate capital structure, it could have severe adverse consequences and hence, one of the assumptions of the Modigliani and Miller theorem would be violated.

Dividend policy could be defined as the policy, which an organisation utilises for structuring its dividend payment to the shareholders. In case of Cochlear Limited, the dividend policy is observed to be constant, as it is distributing a fixed portion of its earnings in the form of dividends each year. Thus, it is following a constant dividend policy, in which the investors are encountering overall volatility of the earnings of the organisation (Kurshev Strebulaev 2015).

Task 2: Capital Budgeting Task

Memorandum

To,

The CEO,

OnePack Limited

From: The Manager

Date: 26^th
May 2019

Subject: Evaluation of the proposed investment

The memo is prepared with the goal for aiding the CEO of OnePack Limited in undertaking the final decision regarding whether to invest or not in the concerned project. Currently, the organisation is experiencing an issue in deciding whether to develop a commercial scale plant along with producing recycled sachet plastic for usage in packaging its own products. Therefore, it is essential to analyse the probable aspects before undertaking the final decision.

1. Explanation of the chosen methods:

In order to ascertain the viability of the proposed project, the capital budgeting methods used include net present value, internal rate of return, payback period and profitability index. It has been identified that a company is prone to certain uses like maintaining the motivation level of the staffs or obtaining materials from suppliers in case of failure of making timely payments although they have considerable amount of profit (Andor, Mohanty and Toth 2015). Therefore, annual cash flows of the proposed project are computed for determining the cash flow position before making the final decision.

On the other hand, the capital budgeting techniques are considered as extremely useful tools for analysing the profitability of proposed investment. This is because these methods consider cash flows along with risk and return position of the organisation (Rossi 2014). Finally, with the help of NPV, it becomes possible for any organisation to increase its value.

2. Inputs and assumptions made:

Base case:

It has been identified that OnePack Limited needs to invest $30,000,000 on this project for purchasing plant and equipment, which would have a useful life of six years with no residual value after the project completion. The revenue is expected to grow by 2% per year and there would be further growth in revenue by 2.5% owing to investment in marketing activity over the initial forecasts. The variable costs are expected to rise by 2% from the second year; however, there would be decline of 10% on the current forecasts owing to energy efficiency program. For financing the equipment, OnePack Limited has to obtain bank loan resulted in interest costs of $1,200,000 million per annum. However, it is not considered in the cash flow calculation, since it would double count the financing cost of investment (De Andrés, De Fuente and San Martín 2015). Moreover, depreciation expense is deducted from revenue for computing net income; however, it is added back with net income for computing the yearly cash flows.

Optimistic case and pessimistic case:

All the above assumptions would remain the same in the two cases, except certain changes in the value drivers, which are stated as follows:

• 
  

  2% increase in revenue for optimistic case and 2% decrease in pessimistic case

  
  


• 
  

  2% additional growth in revenue owing to marketing costs and 2% lower revenue growth for optimistic and pessimistic cases respectively

  
  


• 
  

  There would no increase in variable costs and reduction is expected to rise further by 12% for optimistic case and variable costs would rise to 4% and decline is reduced to 8% for pessimistic case.
  

  
  

3. Summary of findings:

The outcomes of the capital budgeting techniques are presented in the form of tables for the base case (
Refer to Appendices, Appendix 1
). From the tables, it could be clearly seen that the net present value (NPV) of the proposed project is computed as $1,414,456,128. In this context, it is necessary to mention that the higher the NPV of a project, the better it is in terms of investment (Daunfeldt and Hartwig 2014). Thus, from the perspective of NPV, the concerned project would fetch profits to OnePack Limited.

Internal rate of return (IRR) assists in determining the overall rate of return on investment and if it is higher than the cost of capital, the project is feasible to be undertaken (Chittenden and Derregia 2015). In this case, the IRR is computed as 795%, which is significantly higher than the cost of capital of 9%. Thus, in terms of IRR, the project would maximise overall return on investment for OnePack Limited.

Payback period is used for finding out the amount of time required for recouping the initial investment made in a project (Rossi 2015). In this case, the payback period is computed as 0.13 years and the economic life of the project is 6 years. This implies that OnePack Limited would be able to recover its initial investment of $35,450,000 even before the completion of the first year; thereby, denoting the feasibility of the project.

Profitability index (PI) denotes the ratio of payoff to investment of any particular project and if it has value of above 1, it implies that the project would yield significant benefits to the organisation (Bierman Jr and Smidt 2014). In this case, PI is computed as 40.90, which denotes that the project would result in significant benefits for OnePack Limited.

4. Sensitivity analysis:

The outcomes of the capital budgeting techniques are presented in the form of tables for the optimistic case and the pessimistic case (
Refer to Appendices, Appendix 2 and Appendix 3
). For optimistic case, there has been increase in all the above capital budgeting techniques, except payback period owing to the fact that this method ignores the time value of money (Wnuk-Pel 2014). On the other hand, despite the fall in the above capital budgeting techniques except payback period, all values are well above the ideal standard and hence, they imply the feasibility of the project for OnePack Limited.

5. Recommendations:

Based on the above analyses, it has been found that the significant generation of expected revenue would be able to offset the project costs and initial investments by a significant margin. This has been further validated with the use of capital budgeting techniques and therefore, it is recommended to proceed with the project for increasing its profitability in future.

6. Further or follow-up matters:

There are certain uncertainties associated with a project, which mainly interruptions and delays and the quality of materials required for the project. For avoiding any interruptions and delays, a project team needs to be formed and there should be appropriate delegation of authority to the respective personnel (Nurullah and Kengatharan 2015). In order to ensure material quality, a special team has to be formed that would visit the sites of the supplier by conducting frequent audits (Schlegel, Frankand Britzelmaier2016).

Conclusion:

It is apparent from the above discussion that Cochlear Limited follows appropriate capital structure and constant dividend policy. On the other hand, the use of capital budgeting techniques suggesta that OnePack Limited should undertake the project for maximising its profitability.

References:

Andor, G., Mohanty, S.K. and Toth, T., 2015. Capital budgeting practices: A survey of Central and Eastern European firms.Emerging Markets Review,23, pp.148-172.

Bierman Jr, H. and Smidt, S., 2014.Advanced capital budgeting: Refinements in the economic analysis of investment projects. Routledge.

Chittenden, F. and Derregia, M., 2015. Uncertainty, irreversibility and the use of ‘rules of thumb’in capital budgeting.The British Accounting Review,47(3), pp.225-236.

Cochlear.com., 2019. [online] Available at: https://www.cochlear.com/43d56bcc-d510-4a20-ab70-6208fa5af77e/en_annualreport2018_cochlear2018annualreport_5.69mb.pdf?MOD=AJPERES&CONVERT_TO=url&CACHEID=ROOTWORKSPACE-43d56bcc-d510-4a20-ab70-6208fa5af77e-mkRS5RK [Accessed 26 May 2019].

Daunfeldt, S.O. and Hartwig, F., 2014. What determines the use of capital budgeting methods?: Evidence from Swedish listed companies.Journal of Finance and Economics,2(4), pp.101-112.

De Andrés, P., De Fuente, G. and San Martín, P., 2015. Capital budgeting practices in Spain.BRQ Business Research Quarterly,18(1), pp.37-56.

Faccio, M. and Xu, J., 2015. Taxes and capital structure.Journal of Financial and Quantitative Analysis,50(3), pp.277-300.

Graham, J.R., Leary, M.T. and Roberts, M.R., 2015. A century of capital structure: The leveraging of corporate America.Journal of Financial Economics,118(3), pp.658-683.

Kurshev, A. and Strebulaev, I.A., 2015. Firm size and capital structure.Quarterly Journal of Finance,5(03), p.155-168.

Nurullah, M. and Kengatharan, L., 2015. Capital budgeting practices: evidence from Sri Lanka.Journal of Advances in Management Research,12(1), pp.55-82.

Öztekin, Ö., 2015. Capital structure decisions around the world: which factors are reliably important?.Journal of Financial and Quantitative Analysis,50(3), pp.301-323.

Robb, A.M. and Robinson, D.T., 2014. The capital structure decisions of new firms.The Review of Financial Studies,27(1), pp.153-179.

Rossi, M., 2014. Capital budgeting in Europe: confronting theory with practice.International Journal of Managerial and Financial Accounting,6(4), pp.341-356.

Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy.International Journal of Management Practice,8(1), pp.43-56.

Schlegel, D., Frank, F. and Britzelmaier, B., 2016. Investment decisions and capital budgeting practices in German manufacturing companies.International Journal of Business and Globalisation,16(1), pp.66-78.

Wnuk-Pel, T., 2014. The practice and factors determining the selection of capital budgeting methods–evidence from the field.Procedia-Social and Behavioral Sciences,156, pp.612-616.

Appendices:

Appendix 1: Base case analysis

Appendix 2: Pessimistic case analysis

Appendix 3: Optimistic c