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:
-
Free cash flow to the firm also referred to as “ unlevered “
-
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:
-
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)
-
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.
-
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
-
Capital expenditure: it is possible to derive capital expenditure for a company without the cash flow statement
-
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 |
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 |
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 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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|
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|
|
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|
|
|
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 |
|
|
|
|
|
|
|
|
|
|
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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|
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|
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|
|
|
|
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% |
|
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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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