TVforall CC, a television and related equipment retailer is conducting a capital budgeting…

TVforall CC, a television and related equipment retailer is conducting a capital budgeting exercise for the coming year. The company has decided that it needs to urgently review its plans and increase its allocation for interactive displays in its shops.

An external bookkeeper that the company uses for payroll and VAT purposes performed the NPV analysis at the behest of the company but made it clear that he specialises in tax issues and not capital budgeting and that the company should pay for a consultant to assist them. Having reviewed the NPV analysis and findings, the management was unsure regarding the accuracy of the findings and hired you to assist them.

The bookkeeper shared his workings and method followed in a call with yourself and management.

He explained his steps as per the meeting minutes below:

“

Bookkeeper: Hi, thanks for this opportunity, I just want to make it clear that I specialise in tax issues and last did a NPV analysis at university. There may be some mistakes or older techniques used in my analysis and I am glad that it is being revised.

Manager: Thank you, we have taken up your advice, can you please run us through the process you followed so that we can relay this to the consultant.

Bookkeeper: I started off with identifying all the relevant cash flows together with your management team, we identified initial costs inclusive of the purchase price but not installation costs, then we also included a probable increase in net operating working capital requirements in the initial costs.

We then identified the recurring cash flows for the next 5 years of the project which is its estimated lifespan, this included sales generated, variable and fixed costs, the tax deduction for depreciation and the tax payment for each year. All of this was done in today’s terms to make it easier to estimate.

Then, for year 5 and the terminal values related to the project, we also included a probable scrap value for the equipment used in the project on top of the recurring cash flows identified, as described above.

We then calculated the company’s WACC together and used this as the discount rate. Some of us advocated for the use of a risk premium on the WACC for the project due to the possible high variability of the cash flows generated, but no premium was added as the team could not agree on whether it is necessary or not. I calculated the coefficient of variation for the project to be 1.9 whereas previous projects came in with CV’s of less than 1.3.

Manager: Thank you very much for the detailed account and we appreciate your advice to rather consult with the reference you provided.

Bookkeeper: No problem, rather be safe, I really only did it thinking it would be straightforward, but it was not and I am sure there are some miss-steps in my methodology.

“

Required:

1. Carefully read the question and then write, in list form (bullet points) the process you would follow when attempting an inflation and risk adjusted NPV analysis. This includes cash flow identification and possible adjustments to cash flows; also outline the most accurate discount rate to use..

b.) Then, compare the process you outlined to that of the bookkeeper in the case. Highlight which errors, omissions or mistakes may be present in the analysis the bookkeeper described. Provide your answer in list form.

c. ) Lastly, write a brief report (no more than a page) to the management of TVforall CC explaining what they need to revise in their NPV analysis to do it more accurately as per your findings in b. Motivate and explain each of the changes that they need to make for them to make their NPV analysis more accurate.