What are the key items to keep in mind when determining the free cash flows for investment analysis?

While determining the free cash flow for investment analysis, investors need to keep in mind some important information and considerations such as the growing trend of sales revenue during the last few years. Moreover, investors should also understand the key drivers of free cash flow such as EBITDA margins and cash tax rates (usually stated in the notes of income statements or cash flow statements). Moreover, investors should also consider the capital expenditure and working capital of the company during the last few years. A projection of expenses such as marketing and administration expenses also provide a clear idea to the investors in the investment analysis (Corporatefinanceinstitute.com, 2020).

Question: 2

Calculate the weighted average cost of capital (WACC) for Diamond Energy Resources. How does the capital structure of a firm/project affect the WACC?

The following table represents the calculated weighted average cost of capital for Diamond Energy Resources.

According to this table, the calculated weight for debt and equity are 0.3692 and 0.6307 respectively. However, the cost of debt and cost of equity is 14% and 19.82% (in the same order). Thus, based on these calculations the total weighted average cost of capital is 16.38% for the company.

            The capital structure of a firm or company can directly draw impact on its weightage average cost of capital. For instance, an increase in debt will increase the cost of debt. As a result of this, the overall weightage average cost of capital (WACC) will also increase. However, change in the cost of equity will also generate changes in the overall weightage average cost of capital when it increases or decreases in the capital structure of a firm. Usually, equity financing increases weightage average cost of capital as the cost of equity is supposed to be greater than the cost of debt in the firms. 

Question: 3

Produce a projected capital budgeting free cash flow statement for the new mine that PT Diamond Energy Resources Indonesia is assessing for acquisition. Using this information, calculate the Payback, discounted payback, NPV, IRR and Profitability Index (PI) of the project.

The following table represents the capital budgeting free cash flow statement for the company over the next 12 years (from 2015 to 2026). In this table, the free cash flow (annual) is calculated by the use of projected information in the case study about earning before interest and income taxes, depreciation expenses, and change in the networking capital of the company.

             However, PT Diamond Energy Resources Indonesia is going to acquire the equity shares of the new mine, therefore, royalty calculation is also essential while determining and projecting free cash flow for the firm over next 12 year duration. The calculation of free cash flow for the firm over the selected duration we have also calculated earning before interest and taxes (EBIT) and FCF (free cash flow) with the 7% royalty target. The following table will represent the weightage average cost of capital for the firm by the use of information stated in the case study. The WACC is calculated by considering the following information.

1)      Cost of debt

2)      Cost of equity

3)      Weight  for equity and debt

4)      Taxes

Now the calculated answer is 16.38%.

            Based on the shared information in the case study, the payback period and discounted payback period are also calculated for the company. The following table represents the payback period.

               According to the above stated table, company would be able to cover the whole initial investment in 6.5 years (if no changes are made in the cumulative cashflow for each year). Payback period has some limitations as it does not count for the time value therefore another similar evaluation method “discounted payback period” is also calculated for the company. See the following table for discounted payback period.

The above table represents that at the discount rate of 10% annually the company would be able to cover all its initial investment in 7 years duration. Somehow, the case NPV and IRR are 1130 and 17% respectively. The NPV is calculated based on 16.38 WACC. [check excel for further calculation work]

The profitability index is calculated using the following formula:

Thus, profitability index is -2.423.

Question: 4

Sensitivity analysis improves the quality of decision-making in a world of uncertainty. Choose variable(s) which you think is (are) most appropriate to perform sensitivity analysis on. Then, using several scenarios (based on the information provided in the case study and your choice of variables) perform sensitivity analysis. How are payback, discounted payback, NPV, IRR and PI affected by your sensitivity analysis?

            The sensitivity analysis is important for the evaluation of a decision against different factors which can probably generate an impact on the outcomes of the decision. In this case, the royalty percentage is taken as a factor to test the sensitivity of the project. Following tables are representing the sensitivity of scenario 1 and scenario 2 against the royalty percentage 7 and 13.50.

According to the above-stated tables the WACC, IRR and NPV are changed for both scenarios as values are changed.

Impact on IRR

At 7% royalty, scenario 1 and 2 were projecting Internal rate of return (IRR) as 26%. This value is decreased to 17% as we changed royalty value from 7% to 13.50%. a higher internal rate of return is not supportive of the decision as a suitable value for IRR is between 12-15. The following table of WACC is used to calculate WACC for the calculation of sensitivity.  

Conclusively, based on all calculations and shared information in the case study it can be said that different variables will contribute to bringing changes in the value of total return from the decision.

Impact on Payback and Discounted Payback Period:

For instance, the analysis represents that changes in cashflow streams will also influence the payback period and discounted payback period of the selected project. Changes in the annual discounted cashflow (at the rate of 10%) will increase the discounted payback period from 7 years to 10 years duration. Thus, it represent that company would cover the initial expenses of an investment in relatively more time. Thus, the payback period and discounted payback period (calculated for the firm with shared case scenario) will be increased as net cash flow values are changed on an annual basis.

Impact on Profitability Index

 See the following table of profitability index. In this table, the value of profitability for each scenario are lower than the calculated profitability index value for the case (see question 3). Thus, it can be said that scenarios would have negative impact on profitability index.