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Free Essays - Finance Essays

Cash flow forecasts for APZ Developments.

Introduction
APZ Developments plans to introduce new upgrade of an implant. The product will be in the market in 2006. The company plans to use recently refurbished facilities for manufacturing new implant.

The company has already spent some money on patenting the technology. Also the introduction of new implant would reduce the expected sales of current implant in the market. While money already spent shouldn’t influence future investment decision, the expected reduction in profit margins from the existing product should be weighed in decision making.

Appendix I highlights the assumptions made with regard to sales, costs and profits from the new implant.

Other assumptions made in calculating cash flows and NPV

1. The company is generating sufficient profit from existing implant product to utilise tax credit in 2005.
2. Accounting tax is similar to actual cash tax.
3. Money spent on clinical expenditure in 2005 is treated as an expense rather than being capitalised.
4. APZ installs machinery in late 2005 and starts utilising capital allowance in 2006.
5. The company can obtain full tax credit for the write down in book value at the end of 2010.
6. All cash flow transactions are supposed to occur at year end only. Any change in timing of cash flows would impact NPV.
7. Company won’t gain from any reduction in overheads due to lower sales of existing implant.

The book value of new equipment and machinery would be £397,687 at the end of 2010. Appendix II shows book value calculation for capital allowance purpose and it is based on assumption that the company will start utilising capital allowance in 2006 when it starts producing new implants. The book values in the above calculation exclude 20% of the cost reimbursed by the government. The annual capital allowances are then incorporated into the budgeted profit and loss statement to calculate cash tax returns.

Profit and Loss
Appendix III shows the budgeted profit and loss from 2005 to 2010 for new implant for the base case using assumptions in Appendix I. Annual revenues are derived from multiplying unit sales by price per unit, which increases at 3% per annum. Direct costs – labour and material are 25% and 15% of sales and increase at 2% per annum. Reduction in gross margins of existing implant is a consequence of new implant introduction and hence included in profit statement. The new implant is going to use refurbished facility which could otherwise have been rented to a third party for £50,000 per annum. Hence the opportunity cost of loss in rental income is also included in arriving profit and tax calculations for new implant.

Cash Flow
Appendix IV shows the cash flow statement. The calculation doesn’t include payments already made for patents and refurbishment of facilities. We are looking at returns that can be generated in future and so the two payments are like sunk costs and should not have an impact on decision making.

The difference between profit and loss statement, and cash flow statement arise because of the following:

1. Expenditure on equipment and machinery in 2005. It is included
2. One year lag between profit and loss accounting, and cash flows of government rebate and tax payments.
3. Working capital doesn’t impact accounting profit and loss.
4. Absence of non-cash capital allowance in cash statement.

The cumulative expected cash flow between 2005 and 2010 is £6,502,545.

Net Present Value
Appendix V shows the net present value of new implant. The NPV is £3,087,274 with a discount rate of 15%. As the project has positive net present value, the implant is financially viable and APZ Development should proceed with the project.

However the above NPV is based on certain assumptions. Any change in assumptions may have a significant impact on NPV. Sensitivity analysis is used to understand the impact of change in various assumptions on the NPV.

Change in sales volume and price per unit
Sales are one of the most important drivers of NPV. Appendix VI shows NPV sensitivity to both number of units and price per unit. Since variable unit revenue is greater than variable costs of labour, material and overheads, increase in number of units would lead to higher NPV. Variable cost as percentage of sales is less than 100%. Any incremental increase in price would be more than incremental increase in variable costs and so increase in price per unit would result in higher NPV.

Also NPV is more sensitive to inflation in unit price than to change in number of units. This is because price change gets compounded over years.

Change in direct – labour and material costs
Appendix VII shows NPV sensitivity to labour and material costs. As expected, increase in labour and material costs as a percentage of sales would reduce NPV.

The NPV is positive for all scenarios in Appendices VI and VII, and hence APZ should proceed with the project.

Merits of sensitivity analysis

1. It is a relatively simple technique to view impact of individual variables on NPV of a project.
2. Management can then choose variables with highest sensitivity on NPV and focus more on either mitigating negative effects or enhancing the positive effects of changes in them.
3. Short-listing high impact variables helps in prioritising management’s time. It also encourages deeper understanding of high sensitivity variables and thorough market research for those.

Limitations of sensitivity analysis

1. Many variables act in tandem and such relationships are sometimes difficult to be put into simple equations. In these cases sensitivity analysis with respect to such variables doesn’t present full impact picture.
2. In real situation, many variables change simultaneously, a scenario which can not be depicted by a sensitivity analysis.
3. Though it is helpful in decision making, sensitivity analysis doesn’t take into account the overall funding pressures and other financial issues being faced by the company.

Conclusion
APZ Developments should proceed ahead with the further development of upgrade implant. The expected NPV over the life of new product is positive. The sensitivity analysis also shows that new product has positive NPV over a large range of sales and cost variable changes.

Appendix I – Assumptions made in cash flow and NPV calculations

1. Increase in price per unit by 3% per annum
2. Increase in direct costs by 2% per annum
3. Capital allowance to remain constant at 25% of reduced value.
4. Labour and material costs to be 25% and 15% of sales respectively
5. APZ to be able to sell refurbished equipment at £200,000 in 2010.
6. Tax rate = 25%
7. Rate of discount = 15%

Appendix II – Annual capital allowances

	2005	2006	2007
Cost	2,000,000.0
Government reimbursement	-400,000.0
Capital Allowance	0.0	-400,000.0	-300,000.0
Book Value at the end of the year	1,600,000.0	1,200,000.0	900,000.0

2008	2009	2010
-225,000.0	-168,750.0	-126,562.5
675,000.0	506,250.0	379,687.5

Capital allowance in a year = Book value at the beginning of year * 0.25

Appendix III – Budgeted profit and loss

	2005	2006	2007
Units, numbers (A)		600,000	900,000
Price per unit (B)		5.00	5.15
Revenues, (C=A*B)	0.0	3,000,000.0	4,635,000.0
Clinical improvement	-200,000.0	0.0	0.0
Labour costs	0.0	-750,000.0	-1,181,925.0
Material costs	0.0	-450,000.0	-709,155.0
Overhead costs	0.0	-600,000.0	-612,000.0
Reduction in existing implant	0.0	-120,000.0	-95,000.0
Machine overhaul costs	0.0	0.0	0.0
Machine sale	0.0	0.0	0.0
Loss of rental income	-50,000.0	-50,000.0	-50,000.0
Profit Before Tax (D)	-250,000.0	1,030,000.0	1,986,920.0
Capital Allowance (E)	0.0	-400,000.0	-300,000.0
Book value at the end of 2010 (E1)
Taxable Income (F=D+E+E1)	-250,000.0	630,000.0	1,686,920.0
Tax (G) @25% of F	62,500.0	-157,500.0	-421,730.0
Profit After Tax (H=F+G)	-187,500.0	472,500.0	1,265,190.0

2008	2009	2010
1,200,000	1,000,000	800,000
5.30	5.46	5.63
6,365,400.0	5,463,635.0	4,502,035.2
0.0	0.0	0.0
-1,655,640.5	-1,449,513.3	-1,218,286.9
-993,384.3	-869,708.0	-730,972.2
-624,240.0	-636,724.8	-649,459.3
0.0	0.0	0.0
0.0	0.0	-50,000.0
0.0	0.0	200,000.0
-50,000.0	-50,000.0	-50,000.0
3,042,135.1	2,457,688.9	2,003,316.9
-225,000.0	-168,750.0	-126,562.5
		-379,687.5
2,817,135.1	2,288,938.9	1,497,066.9
-704,283.8	-572,234.7	-374,266.7
2,112,851.4	1,716,704.2	1,122,800.1

Per unit cost increases by 3% per annum
Labour and material costs are calculated at 25% and 15% of revenue and increasing at 2% per annum.
Overhead costs increase by 2% per annum.

Appendix IV – Cash Flows

	2005	2006	2007
Expenditure on clinical improvement	-200,000.0	0.0	0.0
Equipment	-2,000,000.0	0.0	0.0
Government rebate	0.0	400,000.0	0.0
Revenue	0.0	3,000,000.0	4,635,000.0
Labour costs	0.0	-750,000.0	-1,181,925.0
Material costs	0.0	-450,000.0	-709,155.0
Overhead costs	0.0	-600,000.0	-612,000.0
Reduction in existing implant	0.0	-120,000.0	-95,000.0
Machine overhaul costs	0.0	0.0	0.0
Machine sale	0.0	0.0	0.0
Change in working capital	-220,000.0	-90,000.0	-120,000.0
Lost rental income	-50,000.0	-50,000.0	-50,000.0
Tax	0.0	62,500.0	-157,500.0
Net cash inflow/(outflow)	-2,470,000.0	1,402,500.0	1,709,420.0

	2008	2009	2010	2011
Expenditure on clinical improvement	0.0	0.0	0.0	0.0
Equipment	0.0	0.0	0.0	0.0
Government rebate	0.0	0.0	0.0	0.0
Revenue	6,365,400.0	5,463,635.0	4,502,035.2	0.0
Labour costs	-1,655,640.5	-1,449,513.3	-1,218,286.9	0.0
Material costs	-993,384.3	-869,708.0	-730,972.2	0.0
Overhead costs	-624,240.0	-636,724.8	-649,459.3	0.0
Reduction in existing implant	0.0	0.0	0.0	0.0
Machine overhaul costs	0.0	0.0	-50,000.0	0.0
Machine sale	0.0	0.0	200,000.0	0.0
Change in working capital	90,000.0	65,000.0	275,000.0	0.0
Lost rental income	-50,000.0	-50,000.0	-50,000.0	0.0
Tax	-421,730.0	-704,283.8	-572,234.7	-374,266.7
Net cash inflow/(outflow)	2,710,405.1	1,818,405.1	1,706,082.1	-374,266.7

Change in working capital in a year = -(Working capital at the end of the year – working capital at the beginning of the year)

Appendix V – Net Present Value

	2005	2006	2007
Net cash inflow/(outflow)	-2,470,000.0	1,402,500.0	1,709,420.0
Discounted @15%	-2,147,826.1	1,060,491.5	1,123,971.4
Net Present Value	3,087,274.1

2008	2009	2010	2011
2,710,405.1	1,818,405.1	1,706,082.1	-374,266.7
1,549,682.9	904,068.7	737,586.4	-140,700.7

Appendix VI – Sensitivity analysis with respect to price per unit and number of units

		Price change
	3,087,274	-10%	-8%	-6%	-4%	-2%	0%	2%	4%
No. of units	-20%	770,657	919,757	1,074,332	1,234,535	1,400,521	1,572,447	1,750,473	1,934,761
	-15%	1,015,072	1,173,490	1,337,726	1,507,942	1,684,302	1,866,973	2,056,126	2,251,932
	-10%	1,259,486	1,427,224	1,601,121	1,781,349	1,968,083	2,161,500	2,361,779	2,569,103
	-5%	1,503,901	1,680,957	1,864,515	2,054,756	2,251,864	2,456,026	2,667,432	2,886,274
	0%	1,748,316	1,934,691	2,127,909	2,328,163	2,535,645	2,750,553	2,973,085	3,203,445
	5%	1,992,731	2,188,424	2,391,304	2,601,570	2,819,426	3,045,079	3,278,739	3,520,617
	10%	2,237,145	2,442,157	2,654,698	2,874,977	3,103,208	3,339,606	3,584,392	3,837,788
	15%	2,481,560	2,695,891	2,918,092	3,148,384	3,386,989	3,634,133	3,890,045	4,154,959
	20%	2,725,975	2,949,624	3,181,487	3,421,791	3,670,770	3,928,659	4,195,698	4,472,130

Appendix VII – Sensitivity analysis with respect to change in direct costs as percentage of sales

		Labour cost
	3,087,274	20%	22%	24%	26%	28%	30%
Material cost	10%	4,194,892	3,973,368	3,751,845	3,530,321	3,308,798	3,087,274
	12%	3,973,368	3,751,845	3,530,321	3,308,798	3,087,274	2,865,751
	14%	3,751,845	3,530,321	3,308,798	3,087,274	2,865,751	2,644,227
	16%	3,530,321	3,308,798	3,087,274	2,865,751	2,644,227	2,422,703
	18%	3,308,798	3,087,274	2,865,751	2,644,227	2,422,703	2,201,180
	20%	3,087,274	2,865,751	2,644,227	2,422,703	2,201,180	1,979,656

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