Business Accounting & Finance ‘Diamond Energy Resources’ Assignment Sample

Question (i)

Free Cash flows in investment analysis

Free cash flow (FCF) measures a company’s financial performance. It shows the cash that a company can produce after deducting the purchase of assets such as property,equipment and other major investments from its operating cash flow. In other words FCF measures a company’s ability to produce what investors care most about: cash that’s available to be distributed in a discretionary way.

There are 2 two most common types of cash flows:

  1. Free cash flow to the firm also referred to as “ unlevered “

  2. Free cash flow to equity also knows as “ levered”

Free cash flows enable the management to decide on future ventures that would improve shareholder value. Abundant FCF helps in expanding business operations. FCF is more transparent in showing the company’s ability to produce cash and profits.

Key items to keep in mind when determining free cash flows for investment analysis:

  1. Cash from operations and net income: it is the net income plus any non-cash expenses adjusted for changes in non-cash working capital ( accounts receivables , inventory , accounts payable)

  2. Non-cashexpenses: the most common items that do not affect cash are depreciation and amortization, stock based compensation, impairment charges and gains /losses on investments.

  3. Changes in non-cash net working capital : calculating the changes in non-cash net working capital is typically the most complicated step in deriving the FCF formula especially if the company has a complex balance sheet

  4. Capital expenditure: it is possible to derive capital expenditure for a company without the cash flow statement

  5. Combining the components of the FCF formula: FCF = net income +non-cash expenses – increase in working capital – capital expenditure.

Question (ii)

Risk free rate

7.50%

tax rate

25%

market risk premium

8.80%

Beta

1.4

average leverage of comparable companies

59%

 

 

in ($)

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

 

debt financing

$12,000

$12,000

$10,800

$9,720

$8,748

$7,873

$7,086

$6,377

$5,740

$5,166

$4,649

$4,184

 

equity financing

$3,000

$20,500

$20,500

$20,500

$20,500

$20,500

$20,500

$20,500

$20,500

$20,500

$20,500

$20,500

 

total financing

$15,000

$32,500

$31,300

$30,220

$29,248

$28,373

$27,586

$26,877

$26,240

$25,666

$25,149

$24,684

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

debt financing %

80%

37%

35%

32%

30%

28%

26%

24%

22%

20%

18%

17%

 

equity financing %

20%

63%

65%

68%

70%

72%

74%

76%

78%

80%

82%

83%

 

Total

100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

cost of equity

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

WACC

12.4%

16.4%

16.6%

16.8%

17.0%

17.2%

17.4%

17.6%

17.8%

17.9%

18.1%

18.2%

 

In financial management, capital structure theory refers to a systematic approachto financing business activities through a combination of equities and debt. There are several competing capital structure theories, each of which explores the relationship between debt financing, equity financing and the market value of the firm slightly differently.

In other words if there is an increase in the debt ratio the interest payment of the company will rise reducing the profitability of the company , but debt has also an advantage as the interest paid on debt is tax deductible thus reducing the overall cost of debt. Whereas in equity there is no fixed payments but it encourages ownership dilution which can be harmful for the business.  This may delay the important decisions that need to be made for the long term prospects of the company.

The most commonly used theory is M&M (Modigliani and miller) theory. They were professors who studied capital structure theory and collaborated to develop the capital structure irrelevance proposition. There were two propositions.

Proposition 1 states that the capital structure is irrelevant for the firm and all the firm should be valued as per there estimated earnings. This proposition was valid when there was no tax.

Proposition 2 states that there should be a mix of both the financing (equity and debt) and the best capital structure is the one that minimizes the cost of capital with the help of right mix of equity and debt financing. Debt should also be part of the capital structure as it is tax deductible.

The capital structure of a company also helps investor to understand the company. The first source from where the company should be utilizing and investing money is retained earnings. The second choice should be debt. This shows that the management is confident that they will be able to repay the debt as well as interest in a timely manner from the profit earned from the project. Equity issue gives an impression that the company is unsure whether the company will be able to make the project successful and thus trying to mollify the risk by reducing their stakes.

Therefore to conclude as we all know that WACC is the mix of both debt and equity. It will help us to make an informed decision of how to finance the project.

Question (iii)

tax rate

25%

Royalties

13.50%

inflation

5%

total value

30000

no of years

10

 

 

 

Year

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

coal price

45

45

45

50

50.0

50

50

60

60

60

60

60

operating
 expenses

25

26.3

27.6

28.9

30.4

31.9

33.5

35.2

36.9

38.8

40.7

42.8

production

0

0

1000

1000

1000

1000

1000

1000

1000

1000

1000

1000

 

income statement

 

 

 

 

 

 

 

 

 

 

 

 

 

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

Revenue

0

0

45000

50000

50000

50000

50000

60000

60000

60000

60000

60000

Royalties

0

0

6075

6750

6750

6750

6750

8100

8100

8100

8100

8100

operating expenses

0

0

27563

28941

30388

31907

33502

35178

36936

38783

40722

42758

depreciation

 

 

3000

3000

3000

3000

3000

3000

3000

3000

3000

3000

EBIT

0

0

8363

11309

9862

8343

6748

13722

11964

10117

8178

6142

interest payment

 

0

1680

1512

1361

1225

1102

992

893

804

723

651

EBT

0

0

6683

9797

8502

7118

5645

12730

11071

9313

7454

5491

Taxes

 

 

1671

2449

2125

1780

1411

3183

2768

2328

1864

1373

NET INCOME

0

0

5012

7348

6376

5339

4234

9548

8303

6985

5591

4118

 

 

 

 

 

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

initial cash outflow

-15000

-15000

 

 

 

 

 

 

 

 

 

 

working capital

 

-2500

-2500

-2500

-2500

-2500

-2500

-2500

-2500

-2500

-2500

 

net income

0

0

5012

7348

6376

5339

4234

9548

8303

6985

5591

4118

depreciation

0

0

3000

3000

3000

3000

3000

3000

3000

3000

3000

3000

working capital release

 

 

 

 

 

 

 

 

 

 

25000

net cash flows

-15000

-17500

5512

7848

6876

5839

4734

10048

8803

7485

6091

32118

 

PAYBACK PERIOD

 

year

year

cash flow

balance

 

0

2015

-15000

-15000

 

1

2016

-17500

-32500

 

2

2017

5512

-26988

 

3

2018

7848

-19140

 

4

2019

6876

-12264

 

5

2020

5839

-6425

 

6

2021

4734

-1691

 

7

2022

10048

8357

 

8

2023

8803

17160

 

9

2024

7485

24645

 

10

2025

6091

30735

 

11

2026

32118

62853

 

 

 

62853

6.36

years

 

 

Profitability index

1.0

 

 

 

DISCOUNTED PAYBACK PERIOD

cost of equity

discounted
 cash flow

balance

 

19.8%

-15000

-15000

 

19.8%

-14605

-29605

 

19.8%

3839

-25766

 

19.8%

4562

-21204

 

19.8%

3336

-17868

 

19.8%

2364

-15504

 

19.8%

1600

-13904

 

19.8%

2834

-11070

 

19.8%

2072

-8998

 

19.8%

1470

-7528

 

19.8%

999

-6529

 

19.8%

4395

-2135

 

NPV

-2135

14.12

years

 

Discounted cash flows

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year

0

1

2

3

4

5

6

7

8

9

10

11

residual value

 

in ($)

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

0

 

net cash flow

-15000

-17500

5512

7848

6876

5839

4734

10048

8803

7485

6091

32118

 

 

cost of equity

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

 

 

discounted cash flow

-15000

-14605

3839

4562

3336

2364

1600

2834

2072

1470

999

4395

 

 

 

sum of discounted cash flow(NPV)

-2134.51

IRR

18%

 

 

 

 

 

 

QUESTION (IV)

tax rate

30%

 

 

 

 

 

 

 

 

 

 

 

 

Royalties

15.0%

 

 

 

 

 

 

 

 

 

 

 

 

inflation

5%

 

 

 

 

 

 

 

 

 

 

 

 

total value

30000

 

 

 

 

 

 

 

 

 

 

 

 

no of years

10

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

 

coal price

45

45

45

50

50.0

50

50

60

60

60

60

60

 

operating expenses

25

26.1

27.1

28.2

29.2

30.3

31.3

32.4

33.4

34.5

35.5

36.6

 

production

0

0

1000

1000

1000

1000

1000

1000

1000

1000

1000

1000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

 

Revenue

0

0

45000

50000

50000

50000

50000

60000

60000

60000

60000

60000

 

Royalties

0

0

6750

7500

7500

7500

7500

9000

9000

9000

9000

9000

 

Operating Expenses

0

0

27100

28150

29200

30250

31300

32350

33400

34450

35500

36550

 

Depreciation

 

 

3000

3000

3000

3000

3000

3000

3000

3000

3000

3000

 

EBIT

0

0

8150

11350

10300

9250

8200

15650

14600

13550

12500

11450

 

interest payment

0

0

1680

1512

1361

1225

1102

992

893

804

723

651

 

EBT

0

0

6470

9838

8939

8025

7098

14658

13707

12746

11777

10799

 

Taxes

 

 

1941

2951

2682

2408

2129

4397

4112

3824

3533

3240

 

NET INCOME

0

0

4529

6887

6257

5618

4968

10261

9595

8923

8244

7559

 

initial cash outflow

-15000

-15000

 

 

 

 

 

 

 

 

 

 

 

working capital

 

-2500

-2500

-2500

-2500

-2500

-2500

-2500

-2500

-2500

-2500

 

 

NET INCOME

0

0

4529

6887

6257

5618

4968

10261

9595

8923

8244

7559

 

depreciation

0

0

0

0

0

0

0

0

0

0

0

0

 

working capital release

 

 

 

 

 

 

 

 

 

 

 

25000

 

net cash flows

-15000

-17500

2029

4387

3757

3118

2468

7761

7095

6423

5744

32559

 

cost of equity

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

19.8%

 

Year

0

1

2

3

4

5

6

7

8

9

10

11

 

discounted cash flow

-15000

-14608

1414

2551

1824

1263

835

2191

1672

1264

943

4463

 

NPV

($11,187)

 

 

 

 

 

 

 

 

 

 

 

 

IRR

12%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sensitivity analysis is a financial model that determines how target variables are affected on changes in other variables known as input variables. This model is also referred to as what if analysis or simulation analysis. It is a way to predict the outcomes of a decision given a certain range of variables.

Therefore we have built a sensitivity analysis by taking some pre-determined values.

We have assumed:

Therefore from the above variables we have undergone a sensitivity analysis. By increasing the tax rate and royalties the NPV of the project is -$11187 therefore the first parameter of choosing any project is NPV. As the NPV is negative therefore we should not opt the project when tax rate=30% and royalties =15%. The IRR of the project is 12% which is less compared to the actual figures given.

YEAR

Cash flow

balance

discounted cash flow

balance

0

-15000

-15000

-15000

-15000

1

-17500

-32500

-14608

-29608

2

2029

-30471

1414

-28194

3

4387

-26084

2551

-25643

4

3757

-22327

1824

-23818

5

3118

-19209

1263

-22555

6

2468

-16741

835

-21720

7

7761

-8980

2191

-19529

8

7095

-1885

1672

-17857

9

6423

4537

1264

-16593

10

5744

10281

943

-15650

11

32559

42840

4463

-11187

payback period

 

11

 

 

 

 

 

 

 

 

sensitivity analysis ( tax rate)

 

sensitivity analysis ( royalties)

 

tax rate

IRR

royalties

IRR

30%

12%

15%

12%

40%

9%

10%

16%

20%

14%

20%

7%

10%

17%

5%

21%

 

Question (v)

There are some benefits as well as some drawbacks relating to the investment. Therefore to start with the benefits the investment will increase the production capacity of Diamond Resources Company which will reduce their operating expenses further. As with the new regularities the small and medium players will not be able to survive thus this can be advantageous for the company to increase the market share of the company to a great extent as their will only be few large players in the market who will be able to survive.

The drawbacks of the investment that most of the parameters is giving a red signal as it is less likely that the investment will be a successful one and with the stringent regulations of being able to produce a stipulated tons of coal this may hurt the company as the operating expenses will increase and thus increasing their losses.

Question (VI)

From the various parameters like NPV, IRR, PI, payback period and discounted payback period we can conclude that we should not make the investment.

From the above calculation we can conclude that NPV is negative. Generally when PI is greater than 1 it is considered to be favorable for accepting the project but as the PI=1 therefore it has a neutral view. The payback period is 6 years whereas the discounted payback period is 14 years thus making the investment unfavorable

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