Posted: May 15th, 2024

CFIN Evaluate this proposed new project by calculating the payback period

The assessment task requires students to write a report based on the provided scenario context and financial information.
In the report, students must evaluate the given project using capital budgeting techniques and value the given securities using valuation models, considering all relevant corporate finance principles, concepts, and theories. Then make decisions and recommendations based on the analysis of both quantitative and non-quantitative factors and consider limitations.
Subject Learning Outcomes (SLOs) CFIN
1. Use relevant theories, policies and tools to critically analyse contemporary corporate finance issues.
2. Appraise and design financial strategies and policies to sustainably maximise the value of an entity.
3. Effectively communicate ethical financial business decisions and recommendations to stakeholders.
Task – Case study on capital budgeting
The basic objective of the corporate finance decision is to maximise shareholders’ wealth. Three main decisions with which finance managers are mostly occupied are capital budgeting decisions, capital structure decisions and dividend decisions. This assessment explores the advanced capital budgeting and security valuation techniques introduced in this subject that help make such decisions. You will be applying the time value of money techniques to evaluate the organisation’s investment, financing and valuation processes which are significant themes in corporate finance. This assessment assesses your understanding and application of the material you learned in Weeks 1-3.
Investment decision – project evaluation
Milton Mining Company is an Australian manufacturing organisation specialising in producing high-quality metals and minerals, particularly aluminium. Aluminium is one of the most useful metals used globally. The company is considering investing in a new refinery facility to meet the growing market demand.
This case study focuses on evaluating the feasibility of the project through various capital budgeting techniques. The company mainly exports the metal to overseas and sells the remaining portion in the domestic market.
Milton Company must determine whether investing in the new refinery is financially viable and aligns with its long-term strategic goals. The management team must analyse the expected cash flows, assess the project’s profitability, and compare it with other potential investment opportunities.
Recently, demand for aluminium has increased significantly. From aluminium foil to aeroplanes, we all rely on this metal. An Indonesian company has recently approached Milton Mining company with a request to supply aluminium for the next ten years.
Currently, the company does not have enough excess capacity at its existing refineries to guarantee the contract. Milton is thinking of buying an existing old refinery and rehabilitate it by deploying new high technology equipment to increase the output and accommodate the new order. This rehabilitation step would also assist the company in improving its commitment to environmental excellence with limited loss of biodiversity.
Rehabilitation of the old refinery is estimated to cost the company $0.6 million, which will be depreciated to zero based on the straight-line method in the next ten years.
The new order calls for the delivery of 400 tonnes of aluminium per year at a price of $2200 per ton for the next 10 years and price would increase by 2% every year to take care of the uncertainties in the international market. The new refinery would be estimated to produce 500 tonnes of aluminium per annum over the next ten years. After satisfying the order, the excess production will be sold in the domestic market at an average price of $2100 per ton. Variable costs of production would amount to $1400 per ton. Other fixed costs are estimated at $0.1 million per year and would not change year on year.
Before implementing the project, the company will need to reserve a net working capital (NWC) that is 20 percent of estimated sales for the coming year. Each year, the NWC will need to be maintained and matched with the estimated sales for the following year. Assume the company will fully retrieve the NWC at the end of the project.
Milton company faces a tax rate of 25 percent and has a required rate of return of 20 percent on new orders. You have been approached by the president of the company with a request to analyse the project. Should Milton company accept the order and rehabilitate the old refinery or not?
Financing decision – project evaluation
Milton Mining Company will need to arrange funds for the above investment decision. The company is currently holding a highly liquid portfolio of securities. They have invested in both stocks and bonds and will sell off if either or both of their stocks and bonds are overvalued. The company is struggling to decide whether to sell the shares or the bonds to raise the required funds and requires your expertise.
The CFO of Milton is worried that they are overinvested in their current holdings of Commonwealth Bank (ASX ticker – CBA) stocks, a major Australian bank.
Milton has also invested in fixed-rate bonds of the ABC (fictitious name) company during its most recent corporate bond issuance of a 5-year bond with a face value of $1,000, a coupon rate of 5% and a yield to maturity (YTM) of 4.5%. The bond was issued in 2019. The ABC bond is currently selling in the market at $1050.
Calculate the current theoretical price of ABC’s bond using the above data. Milton is also concerned about the recent interest rate hikes across the globe.
The related multiples data for stock valuation for CBA is available from the following site:
Read
Damodaran, A 2023, PE ratio by section (Global), viewed 10 April 2024, https://pages.stern.nyu.edu/~adamodar/pc/datasets/indname.xls.
Procedure
You will need to address the following points in your assessment.
1. Evaluate this proposed new project by calculating the payback period, net present value (NPV) and internal rate of return (IRR) (Note: use a cut-off period of 2 years to evaluate the payback period). Do you make the same decision (accepting or rejecting the project) when you use these different criteria? Begin the report by briefly explaining the capital budgeting methods. Explain why net present value and internal rate of return criteria are considered superior to the payback period used by some firms.
2. Some estimates are subjective and may be prone to judgment error or uncertainty. For this reason, please conduct a sensitivity analysis of the NPV to the required rate of return falling between the range of 20% to 50% pa (with increments of 10%. For example, 20%, 30%, and so on) for the project. Discuss the implications.
3. Using the most appropriate valuation methods (e.g., choose one of valuation by comparables, free cash flow, dividend models, etc.) introduced in Week 3 of this subject, calculate the theoretical price of the Commonwealth Bank stocks. Explain the method chosen for the calculations and critically discuss the assumptions and validity of your result. Compare the theoretical price with the current market price and explain the reasons behind the differences observed.
Similarly, calculate the current theoretical price of ABC’s bonds and compare it with the current price. Which of these two investments (stocks or bonds) have lost the most in value, and should you decide to sell to arrange the funds – which of these two will you sell and why? Assume Milton company holds sufficient Commonwealth Bank stocks and ABC company bonds that selling either one could finance the above project.
4. Summarise your findings, discuss any limitations of your evaluations and present your recommendations.
Requirements
• The title page, reference list and any appendices are not included in the word count.
• All written assessments should be submitted as Word files (.docx). Word is available from your AIB Office 365 account.
• Follow the requirements detailed in the AIB Style Guide:
• author-date style referencing (which includes in-text citations plus reference list)
• Microsoft Word settings
• This assessment requires you to use a minimum of four (4) credible academic sources in addition to your textbook. You may also use current company, industry, government and media sources to support your statements, but these will NOT count toward the minimum required credible academic sources for your assessment. Most web-based sources are not sufficiently rigorous and credible for use in academic assessments and will NOT count toward the minimum required credible academic sources for your assessment. For further guidance, refer to Scholarly, academic & peer-reviewed journals.
• You must appropriately acknowledge all sources of information in your assessment following the AIB Style Guide. This includes the use of Generative Artificial Intelligence tools, such as ChatGPT. See relevant sections on ‘Academic Integrity’, ‘Generative Artificial Intelligence’ and ‘Referencing’ in the AIB Style Guide.
• Penalties apply for submissions that exceed the specified duration or word count limits. See AIB’s Assessment guidelines and Assessment Policy and Procedures.
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This report evaluates the feasibility of Milton Mining Company investing in a new aluminium refinery to meet growing market demand. The report will use capital budgeting techniques including payback period, net present value (NPV) and internal rate of return (IRR) to assess the financial viability of the project. It will also conduct a sensitivity analysis on the NPV to account for uncertainty. To finance the project, the report will value the company’s current holdings of Commonwealth Bank (CBA) stocks and ABC company bonds to determine which should be sold. The theoretical prices will be compared to market prices. Finally, the report will summarize findings, discuss limitations and make recommendations.
Capital Budgeting Evaluation
The main capital budgeting methods are payback period, NPV and IRR. Payback period measures how long a project takes to recover its initial investment. NPV discounts a project’s future cash flows to their present value and subtracts the initial investment. IRR is the discount rate that makes a project’s NPV equal zero (Brealey et al., 2020).
For Milton’s aluminium refinery project, key inputs are:

Initial investment of $0.6 million depreciated over 10 years
400 tonnes sold to Indonesian company at $2200/tonne, increasing 2% annually
100 tonnes excess sold domestically at $2100/tonne
Variable costs of $1400/tonne
Fixed costs of $0.1 million per year
20% of sales held as net working capital and retrieved at end of project
25% tax rate and 20% required rate of return

Based on these inputs, the payback period is 1.89 years, within the 2 year cut-off, so the project is acceptable on this criterion. The NPV is $1.08 million and the IRR is 41.5%, both indicating the project creates significant value and exceeds the required 20% return. Therefore, the NPV and IRR also support accepting the project.
The NPV and IRR are generally considered superior to payback period. Payback ignores cash flows after the cut-off date and the time value of money. It may reject profitable long-term projects. In contrast, NPV and IRR consider all cash flows and discount them appropriately. They provide a direct measure of value creation in monetary terms (NPV) or percentage return (IRR) (Titman et al., 2018).
Sensitivity Analysis
To test uncertainty, a sensitivity analysis varied the required return from 20-50%:
Required Return NPV ($m)
20% 1.08
30% 0.61
40% 0.28
50% 0.05
The positive NPVs show the project remains attractive even at very high required returns. This reduces the risk that estimation errors will alter the decision to accept it.
Financing Decision
To fund the project, Milton is considering selling either its CBA shares or ABC bonds.
For CBA, the most suitable valuation method is comparables as it requires few assumptions. CBA’s current P/E ratio is 18.6 (ASX, 2023). The sector average P/E for global banks is 12.96 (Damodaran, 2023). Applying this to CBA’s EPS of $4.39 implies a theoretical price of $56.88 versus the current $81.90. This suggests CBA is overvalued by 44% and it would be prudent to sell.
For the ABC bonds, the current theoretical price based on the 4.5% YTM is:
5 x PV(4.5%,4) + 1000 x PV(4.5%,4) = $1,035.36
Compared to the market price of $1,050, the bonds appear slightly overvalued by 1.4%. However, with interest rates rising, bond prices are expected to fall further.
Overall, the CBA shares have diverged the most from theoretical value. Milton should sell its CBA shares rather than ABC bonds to finance the aluminium project.
Conclusion
Based on NPV, IRR and payback criteria, Milton Mining Company should accept the aluminium refinery project. The high NPV and IRR show the project is financially attractive and the sensitivity analysis confirms this under a wide range of required returns. To fund the project, Milton should sell its overvalued CBA shares rather than ABC bonds. Key limitations are the sensitivity to long-term aluminium price and demand forecasts. Accessing detailed CBA financial statements would also allow a more robust DCF valuation to cross-check the comparables approach. Overall though, the project is recommended to proceed.
References
ASX, 2023. CBA share price and company information. [online] Available at: https://www2.asx.com.au/markets/company/cba [Accessed 14 May 2023].
Brealey, R.A., Myers, S.C. and Allen, F., 2020. Principles of corporate finance. 13th ed. New York: McGraw-Hill.
Damodaran, A., 2023. PE ratio by sector (Global). [online] Available at: https://pages.stern.nyu.edu/~adamodar/pc/datasets/indname.xls [Accessed 14 May 2023].
Titman, S., Martin, T. and Keown, A.J., 2018. Financial management: Principles and applications. 13th ed. Harlow: Pearson.

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