Assume that you have just been hired as a financial consultant to a startup comp
ID: 2712445 • Letter: A
Question
Assume that you have just been hired as a financial consultant to a startup company that plans to introduce a new beverage to the soft drink market. Your company’s product is advertised as a healthier alternative to soda and other artificially flavored drinks. The all-natural sparkling beverage has only 25 calories, 5 grams of sugar, no chemicals or preservatives, and comes in four fruit flavors: orange, pineapple, apple and grape.
Two years ago the product was introduced in Florida. A phenomenal growth in sales since its introduction demonstrates that the product and its marketing possess tremendous potential. Accordingly, the company wants to explore possibly expanding sales of the product to the rest of the U.S. market.
Although the company has been highly profitable, the management group has little to no financial experience. Most decisions to date have been made on the basis of ‘does it feel right’ as opposed to rigorous, data based financial analysis. The company has no system of financial oversight and the managers of the company have a limited understanding of sound management accounting practices.
You have been asked to provide the company with a general analysis of this proposed project. Your specific task is to produce a report discussing the following key aspects of this expansion project:
A microeconomic analysis of the current state of the soft drink market in the U.S. and how any recent developing trends may affect the demand for this product.
A macroeconomic analysis of the state of the U.S. economy and the impact this may have on the demand for this new product.
A list of key management accounting practices that the company must put in place to support their planned expansion. Each item you list must be fully explained to the management group so they understand how and why the practice is necessary to manage the growth that will come with expansion of the product to different states. Be sure to consider the fact that the company will need outside financing and may even consider the possibility of going public in order to sell its stock on an exchange.
Based on the quality of your report, the management group will decide whether or not to hire you to then help them develop a full capital budgeting plan for this project. Because this is something you would like to do, mainly because capital budgeting consulting pays extremely well,
Hpw do I answer this question
Explanation / Answer
Answer: Capital budgeting is the process of making a decision about the financial desirability of a project. The proposed software development project at Digital Solutions is an example of this kind of problem. We will see how Nancy Garcia approaches this problem as a way to learn the techniques of capital budgeting.
The problem in five steps:
1. Determine the relevant cash flows including different possible outcomes.
2. Assess the rough financial viability of the most-likely outcome.
3. Use more sophisticated capital budgeting techniques to evaluate the project.
4. Provide quantitative measures of risks the project faces.
5 Determine how these risks affect the decision to do the project.
The Time-Line of a Capital Project:
The first step in any capital budgeting decision is to list all the relevant cash flows. This is the hardest part of the process since it depends on having a detailed understanding of the business and requires the manager to forecast what will happen with the project in the future. It is also the most important part of the process, since if the cash flows are wrong, measures of the profitability of the project will be wrong too. Many capital projects have a similar structure: An initial investment by a firm, followed by a number of periods of regular cash inflow, followed by a terminal payment that ends the project. Our methods of evaluating projects don’t depend on this structure, but it can be helpful to think of a project this way when determining cash flows in order to be sure that you don’t forget any beginning or ending payments or costs.
Payback Period: Imagine that we have a project that costs $80,000 and returns $20,000 each year over the next 5 years. The sum of the returns ($100,000) exceeds the cost, so on its face the project is worth doing. However, we have ignored the fact that some of the returns to the project are being paid in the future.
Net Present Value:
A better method of evaluation (in fact, the best
method) is called net present value (NPV). The NPV of a project is the just the present value of all the cash flows of the project, including the initial investment. In fact, NPV is just another example of discounted cash flow analysis. Once we know a project’s NPV, we can make a decision about whether we should do it.
Rules for evaluating projects using NPV are:
•If the projects under evaluation are independent, then you should accept all projects with a positive NPV and reject those with a negative NPV.
•If the projects are mutually exclusive, choose the project with the highest NPV (as long as it is greater than 0)
Internal rate of return: A method very similar to NPV is the internal rate of return (IRR). However, instead of reporting the dollar amount of the project, it gives a rate of return. IRR is calculated as the discount rate that equates the present value of cash inflows with the initial investment associated with the project. Another way of saying this is that IRR is the discount rate that sets the NPV of the project equal to zero.
The rules for using IRR are:
• For independent projects, if the IRR is greater than the cost of capital, accept the project. If it is less than the cost of capital, reject the project.
• For mutually exclusive projects, choose the project with the highest IRR, assuming that it is also above the cost of capital.