AFE_7_IFM International Financial Management for Business Assessment Answer

Existing method

Aromatic chemicals had been facing poor financial performance due to the economic slow down causing loss of around 50% of Earning per share from year 2020 to year 2021. The economic slowdown and accumulation of the firms’ common shares by well-known competitor , William bones has caused Aromatic chemicals to face issue. To cop up with the issue, there has been various decision making process in the company to arrive at various conclusion. One amongst them was to pave out the new opportunities using the existing experience to explore more in innovative way. This would require capital expenditure as it relates to expansion of the company project. For taking decision as to capital expenditure, Aromatic chemicals manual has mentioned about the usage of Double Declining balance depreciation method. Applying this approach, a formula was used to compute the accelerated deprecation over coming 10 years period and hence forth, it has been decided to use the straight line method for deprecation. Also, the decisive point for the company as to whether to accept the proposals or not depends upon the ability of capital expenditure to sustain a reasonable proportion of corporate overhead expenses. In case a capital expenditure is not able to do so, then such proposals were declined. Numerically, if a new capital project is able to produce a pre-tax charging amount (profit) which is equivalent to 4% of value of initial asset investment, then such project or expenditures are not to be undertaken. Apart from this, there are four hurdles or conditions that a project should pass in order to be successfully investing project. They are an additional impact on EPS which means that for engineering- efficiency projects, the contribution to the net income should have to be positive. Maximum payback period has been fixed to be at 6 years for engineering -efficiency projects and net present value has to be at positive using 12% of hurdle discount rate as per company Policy and IRR to be greater than 12%. This is the existing system at Aromatic Chemicals to decide upon the capital expenditures.

Capital budgeting technique always gets priority application for determination as to whether the new project will give return to company or not. For this, there are several methods for capital budgeting like determining (SEKHAR, n.d.)Net present value, Payback period, discounted payback period, profitability index, etc. These are the capital budgeting technique which are formally accepted and used across the world to determine the efficiency of budgeting and help in selecting the appropriate investment technique. NPV is determination of the net present value which a project will deliver to the company if invested over period of time.

This intakes the cash value that a project will cater in the ongoing future from its operation (Dr. R. S. Kulshrestha and Rakesh Kulshrestha, 2021). Suppose an investment is made in Year 0, then this will be considered as the outflow at year 0 and any outflow caused for the operation and maintained of the capital investment so made will be deducted from the cash inflows occurring post year 0 to arrive at net cash inflow. Because with time, there comes variation in value of money, NPV considers discounting of the cash flows in the future years at discounting rate which may be company Weighted average cost of capital or industry W Weighted average cost of capital. Post discounting, there arrives the net present value. If NPV is positive then the project should be accepted or else it should be declined as it gives an idea whether the project is going to earn money for the company or not(Cheng Few Lee, Lee and Lee, 2022). Enabling company to take decision in this way would be much easier than using the way that Aromatic Chemicals have been using. The scheme in operation is quite complicated which is completely dedicated towards the machinery usage and not towards the output it is producing . It is expecting that if a project is able to produce 4% of its initial investment as pre-tax profit, then the project is viable.

But this way of decision is not going to make any useful decision as deciding upon an investment this way without considering the benefits it will cater and considering only its depreciation and the net profit will bear a question mark on efficiency of the operation of that capital expenditure. It may be possible that proper cost allocation could not made always to derive at the net profit position. These are in addition to the method enumerated in above paragraph. Methods applied at Aromatic chemicals are though useful but use of hurdle rate at 12% as cost of equity will not be appropriate(Cheng Few Lee, Lee and Lee, 2022). Instead, it should use weighted average cost of capital to determine the NPV of the project as there is mix fund that is both the debt and equity. So, simplified method for the decision of capital expenditure will be NPV method.

While other methods as mentioned above may also be adopted like payback period, which talks about the year of time that company will take to take out its invested amount from the project. This defines the appetite of risk that a company could take. In other words, till how many years company could take risk to invest its capital amount. Similarly, profitability index defines the ratio of profit that company will be able to make from a capital project. Payback period of 6 years at maximum is good decision though.

Impact of EPS is also promising method of determining the viability of project. If the impact is positive ,then only the project has to be taken through. Yet qualitative analysis as to indirect impact has to be measured before arriving at any decision(Grabowski, Harrington and Nunes, 2017).

Transport Division Suggestion

Transport division has suggested to include the cost of tank cars as an initial outlay of Liverpool program. The business model operating in the Aromatic Chemicals required Transport division for the movement of all raw, intermediate and finished material throughout the company. This forms an important part of whole supply chain system to include logistic as important part for the smooth operating environment(Cheng Few Lee, Lee and Lee, 2022). There would be increased production when the proposed capital expenditures would have been taken through, and to accommodate the increased production it would require raw materials in that increased quantity as well as movement of intermediate and finished material will also increase. Because the tank cars are already operating in excess capacity, it would be difficult for them to cover up the scenario in coming days. So, to effectively take decision on the proposed Liverpool project, it is recommended to consider transport division suggestion and include same in DCF analysis.

Director of Sales Suggestion

The suggestion of Directors of sale do have merit because currently there is economic downturn and recission has impacted many competitor. The existing plant capacity at Liverpool is able to cater large customers in hand and making expenses at such recission time with an assumption that the market customers will be back with us, if we stop them providing materials at once on sake of our modernization. Once the customer will go away at this recission time , then it’s quite difficult to presume them back with the company. Also, the company is already on oversupply and as per director of sales, the capacity of Rotterdam could cannibalize requirement at Liverpool, then why should the expense be carried out. So, capabilities charge should be taken in DCF analysis to determine actual value of the proposed project.

Assistant Plant Manager Suggestion

When it came to Assistant plant manager, he offered a change in EPC production line whose cost is GBP 20 million, but negative NPV. He offered to mix this EPC production line with poly renovation as well so that when recission ends, the company will be able to boom with the new products. According to him, though Aromatic Chemicals is largest producer of EPC, the competitors have taken charge of it and EPC has become marginally profitable to the company. As per him, the investment project into EPC and its combination with poly renovation will sink negative NPV and hence the company will decide favorably in their part looking at the two projects. This suggestion is though off track and has no relevance with the Liverpool project. As the company has not allowed to take off the project because of negative NPV and mixing them with the Poly renovation may cause its further rejection(Cheng Few Lee, Lee and Lee, 2022). This suggested change was to kick off the sinking plant with the new one and to prevent the layoff as he is expecting in future.

Treasury Staff Comment on Inflation

Inflation is an important factor which needs to be considered at every capital budgeting decision, as sometimes ignoring them may cause several impact on the long run. Due to inflation , there comes hurdle scenario where raw material needs to be bought at higher cost than it should be. This would increase the cost of production and hence reduces the profitability. So, while making DCF analysis or valuation of any project it is worthwhile important to cater inflation into the discount rate . Treasury staff was focusing more towards the discounted rate that was being taken up by Robert is merely(Grabowski, Harrington and Nunes, 2017) from Aromatic Chemicals manual which do not consider the impact of inflation. So, he suggested to take off the inflation adjusted weighted average cost of capital which would help arrive at accurate value.

Free Cash Flow Vs Equity Cash Flow

It has been correctly mentioned by Senior analyst at Treasury that there exist thin line difference between free cash flow and equity cash flow. Free cash flow is the fund available to the entity as a net income which is availed for funding at various places while Equity cash flow is the only portion which is remaining after payment of all debts, expenses, and reinvestment. Such portion is made available to the equity shareholders(Graybeal, 2019). In other words, equity cash flow may be defined as the dividend while free cash flow includes dividend in it. In free cash flow, all the payment to equity shareholders as well as the debt holders exist while equity cash flow contains only the one to be shared with equity shareholder(Pinto et al., 2015).

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