Risk and Return Analysis Capital Budgeting

Question: Discuss about the Risk and Return Analysis Capital Budgeting. Answer: Introduction An investor earns returns from a stock in the form of dividend and stock price appreciation. For earning this return, he also has to undertake some amount of risk. Risk is the variability in the price of the stock over a period of time. Higher the risk of the stock, more is the expected return. An investor would undertake a risk return analysis before investing in a stock to see if the stock gives better returns than the market at a lower risk. We have done a risk return analysis for the Flight Centre Travel Group for a period of five years and on the basis of the results, have suggested whether it is a good investment or not. Capital Budgeting is a process of determining the feasibility of a project comprising of long term investments in terms of profitability. Some of the capital expenditures include purchase of new plant and machinery, introduction of a new product or process etc. there are various techniques in capital budgeting which can be used to analyse the capital investment. Net present value (NPV) is the most important one and a project is accepted only if the NPV is more than 1. A capital budgeting analysis has been done for ABC ltd. where techniques used are NPV analysis, sensitivity analysis and scenario analysis. Risk and Return Analysis The daily returns, monthly returns and yearly returns and yearly standard deviation for the Flight Centre Travel Group are given in the annexure. The analysis has been done for a period of five years from 01-01-2012 to 31-12-2016. Also the systematic risk/market risk using the daily returns of the market has been calculated in the annexure along with the unsystematic risk (Yahoo. Finance, 2017) On the basis of the above calculations, the beta value for the companys stocks is 0.92. Beta measures the volatility of the stock with respect to the market and an investor can choose between various stocks depending on the beta and his risk appetite. A beta of 1 means that the movement in the stock price is in tandem with the market and if the market price increases by 10%, the stock price will also increase by 10%. A beta of less than 1 means the stock is more stable and does not move in tandem with the market. This reduces the risk of the stock. Here, Flight Travel Group has a beta of 0.92 which means that if the market price reduces by 10%, the stock price of the company will reduce by only 9.2%, thus implying low risk. Hence, for investors who prefer a stable and secure investment, this is a good investment. However, investing only in this stock will not maximize the returns. In order to minimize the risks and maximize the returns, it is important to have a diversified portfolio. The market risk measured by beta or systematic risk cannot be fully eliminated but it can be minimized by diversifying the portfolio. Also the unsystematic risk which is the company specific risk is 1.7%. This risk can be eliminated with diversification. In a diversified portfolio stocks of different companies with different beta should be kept. Stocks with beta more than 1 will give high returns when the market is rising and stocks with beta less than 1 will give returns better than the market when the market is falling, thus maintaining a balance. Apart from stocks, an investor can invest in bonds which have very low risk and returns are assured (Damodaran, NA) Capital Budgeting Capital Budgeting is a process of analysing an investment expenditure to see if it is profitable to make such capital expenditure or not. There are various techniques to do so like NPV, IRR, payback period etc. The new expansion plant project of ABC Ltd. has been analysed using capital budgeting to see if the company should undertake the investment or not. The initial investment outlay of the project is: Building cost $24,000 Equipment $16,000 Net working capital $12,000 Initial investment $52,000 The operating cash flows over the projects life are given below: Year 0 1 2 3 4 Annual sales $80,000 $80,000 $80,000 $80,000 Variable manufacturing costs $48,000 $48,000 $48,000 $48,000 Fixed overhead costs $10,000 $10,000 $10,000 $10,000 Depreciation on building $600 $600 $600 $600 Depreciation on equipment $3,200 $3,200 $3,200 $3,200 Total operating income $18,200 $18,200 $18,200 $18,200 Income Tax@40% $7,280 $7,280 $7,280 $7,280 Profit after tax $10,920 $10,920 $10,920 $10,920 Operating cash flows $14,720 $14,720 $14,720 $14,720 The terminal years cash flows for the ABCs expansion project: Terminal value After tax salvage value Building $17,640 After tax salvage value equipment $3,680 Recovery of working capital $12,000 Terminal value $33,320 Working Notes: Building Building cost $24,000 Book value $21,600 Total depreciation $2,400 Annual depreciation $600 Market value $15,000 Loss on sale $6,600 Tax on loss $2,640 After tax salvage value $17,640 Equipment Equipment $16,000 Book value $3,200 Total depreciation $12,800 Annual depreciation $3,200 Market value $4,000 profit on sale $800 Tax on loss $320 After tax salvage value $3,680 NPV analysis Year 0 1 2 3 4 Operating cash flows $14,720 $14,720 $14,720 $14,720 Initial investment -52000 Terminal value $33,320 Net cash flows -52000 $14,720 $14,720 $14,720 $48,040 Cost of capital @12% $1 $0.893 $0.797 $0.712 $0.636 Present value of cash flows -$52,000 $13,142.9 $11,734.7 $10,477.4 $30,530.3 NPV = $13,885 The project has a positive NPV which makes the project acceptable. A positive NPV means the cash inflows are more than the cash outflow and the project will generate profits for the company. Hence, it is recommended that the company should go ahead with the new plant expansion. Sensitivity Analysis It is a technique used to determine the NPV changes with a change in the various assumptions or estimates of the project. This helps the managers in a proper analysis and preparing them for the worst. The result of sensitivity analysis for the current project by increasing and decreasing the sales, variable costs and cost of capital and their impact on the NPV has been discussed below: Value Drivers Expected NPV Revised NPV % Change Increase in sales by 2% $13,885 $15,052 8.4% Increase in sales by 5% $13,885 $16,801 21.0% Increase in sales by 10% $13,885 $19,717 42.0% Decrease in sales by 2% $13,885 $12,719 -8.4% Decrease in sales by 5% $13,885 $10,969 -21.0% Decrease in sales by 10% $13,885 $8,054 -42.0% Increase in variable costs by 2% $13,885 $12,136 -12.6% Increase in variable costs by 5% $13,885 $9,511 -31.5% Increase in variable costs by 10% $13,885 $5,138 -63.0% Decrease in variable costs by 2% $13,885 $15,635 12.6% Decrease in variable costs by 5% $13,885 $18,259 31.5% Decrease in variable costs by 10% $13,885 $22,633 63.0% Increase in cost of capital by 2% $13,885 $10,618 -23.5% Increase in cost of capital by 5% $13,885 $6,162 -55.6% Increase in cost of capital by 10% $13,885 -$253 -101.8% Decrease in cost of capital by 2% $13,885 $17,418 25.4% Decrease in cost of capital by 5% $13,885 $23,279 67.7% Decrease in cost of capital by 10% $13,885 $34,832 150.9% From the above table we see that cost of capital is the most sensitive factor in this project as with a 10% increase in the cost of capital, the NPV decreases by more than 100%. Also with a decrease in cost of capital by 10%, the NPV increase by 150%, thus making it the most sensitive factor. After cost of capital, it the variable cost which is sensitive to the NPV. With 10% increase in variable costs, the NPV decreases by 63% whereas with a 10% decrease in sales, the NPV decreases only by 42%. Thus cost of capital is the most sensitive factor followed by variable costs and the least sensitive is sales. Scenario Analysis Under scenario analysis, different scenarios are taken where more than 1 input is altered and the impact of such changes is seen in the NPV. Normally there are three scenarios considered which is best case, normal case and worst case. For the current situation, we have assumed the best case as increase in sales by 10%, decrease in variable costs by 10%, and decrease in cost of capital by 10%. For the worst case we have assumed decrease in sales by 10%, increase in variable costs by 10%, and increase in cost of capital by 10%. The results are as follows: Original NPV Revised NPV % Change Best Case $13,885 $54,206 290.4% Normal case $13,885 $13,885 0.0% Worst case $13,885 -$11,504 -182.9% From the above table we see that the NPV increases by 290% in the best case and decreases by 183% in the worst case. Conclusion The risk and return analysis of Flight Centre Travel Group suggests that the stock is a safe stock with a beta less than 1 (0.92) and hence is a good investment for investors with low risk appetite. However, in order to maximize returns, it is suggested that the investor should invest in stocks of other companies with a beta of more than 1. This will diversify his portfolio. Also apart from stocks, he should invest in other securities like bonds and debentures. The capital budgeting analysis of ABC Ltd. new plant expansion project gives a favourable result where the NPV is positive and the project seems favourable. Of all the inputs, cost of capital is the most sensitive factor. Reference Damodaran, A., (NA), Estimating Risk Parameters, Stern School of Business, New York Finance. Yahoo, (2017), SP/ASX 200 (^ AXJO), accessed online on 17th April, 2017, available at https://in.finance.yahoo.com/quote/%5EAXJO?ltr=1 Finance. Yahoo, (2017), Flight Centre Travel Group Limited (FLT.AX), accessed online on 17th April, 2017, available at, https://finance.yahoo.com/quote/flt.ax?ltr=1