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Finance Essays | Cashflows and Capital Budgeting

Research Title: Identify Relevant Cash Flows and apply basic capital budgeting methods.

OneBank PLC .

Introduction to the Firm :

OneBank PLC provides high quality, branded bancassurance products in the UK. The products are sold in limited numbers because of balance sheet and funding constraints and exist for limited periods of usually no more than six years before being phased out and replaced with other products. All products are sold on the phone from a call centre or on the Web. A significant part of the overhead is concerned with the costs of marketing and is shared between up to 20 product items at any one time.
The director of the personal banking division is currently reviewing a number of new product proposals:
¢ Mortgage Loan
¢ Bank Draft
¢ Pension Plan
¢ Car Insurance
¢ Credit Card

Assumptions:
The phasing out process of the earlier products allows us to assume that there is no opportunity cost associated with the phasing out process of the products. The process also allows us to assume that there is no advantage arising out of the phasing out process and the expected cost structure of the products include all the variable costs and fixed costs for the products.

The range of products of the Bank to be evaluated is as follows:
¢ Mortgage Loan (Existing Product)
¢ Bank Draft (Existing Product)
¢ Pension Plan (Existing Product)
¢ Car Insurance (Existing Product)
¢ Credit Card (New Product)

The assumption of no existing benefits or opportunity costs for the old product lines allow us not to use any external adjustments in the decision making process for the given five lines of products. We thus do not differentiate in the evaluation process of the existing product lines and the new product line. So we use the Discounted Cash flow process for the capital budgeting process without introducing any external conditions that is not mentioned in the informations.

The process of Discounted Cash Flow includes the prediction of the expected future cash flows and then to adjust the expected future cash flows with respect to the costs that include the fixed cost, the variable cost and the opportunity cost (for the net present value calculation and decision making process). The Discounted Cash Flow method includes the discounting of the free cash flows created after the adjustments due to the various costs associated with the product. The rate of discount depends on the risk profile of the cash flows for the product and the free cash flow is adjusted accordingly .The rate of discount for any free cash flow beyond the one year horizon includes the cumulative discounting process (the compound discounting). The process of discounting leads to the present value of the free cash flow available for the investor.

The Products are hereby represented as follows for the purpose of the research
¢ Mortgage Loan: A
¢ Bank Draft: B
¢ Pension Plan: C
¢ Car Insurance: D
¢ Credit Card: E

The indirect costs associated with the products A,B,C , D and E are as follows

The 'mortgage loan' (product A) requires the use of new legal services to be sub-contracted costing a total of £38,500. These legal services will have a remaining contract value to the bank of about £13,500 at the end of the six-year product run which can then either be used by the other 14 products or refunded by the legal services provider. The two risk sharing lines (products C & D) and the credit card (product E) will be produced using a part of the group balance sheet, which is being underutilized at present. The credit card (product E) will require the use of a mailing machine otherwise intended for sale immediately for £3,500. However, this equipment has just three years of life left and it is anticipated that it will be replaced at the end of three years at a cost of £14,000 (the equipment will have an estimated value of £6,000 when this products is phased out six years from now).

The mortgage loan (product A) will also use up most of a stock of deeds and other legal documents for property that are otherwise redundant. Four deeds and four stamp duties are needed on each recliner. The duties each have a cost of £1.05 and the deeds each cost £0.90, both are already included in the estimate of funding cost for the mortgage loan.

The cost benefits analysis for the products:

The cost benefit analysis includes the variable cost of production and the indirect cost of production of the units involved in the production. The cost benefit analysis do not include any cost that do not have any other opportunities; for example the costs that are already incurred and the changes in the production plan do not offer any opportunity cost for the products. Here we have got the Contributions per unit by deducting the Staff cost, Funding/ Fees Cost, Overheads from the expected sales price.

The following information concerning costs and prices for each unit of production in GBPs

The Overheads allocated on the basis of staff hours. Overheads include an average of £25 per item for marketing and service delivery. So the total overheads are allocated on the hourly basis and then distributed as per unit cost.

The production patterns of the products are given below: We assume the bank will be able to meet the expectations about the unit sales every year over the given six-year horizon.

The Cost- Benefit analysis and the production figures have offered us the expected cash flow figures for the products for the year 1 to year 6 . The figures are obtained by multiplying the per unit contribution of the units with the number of sales made per product line.

The Cash flow Statement for the products for the 6 year horizon for the One Bank Plc:

The Company has an expected internal rate of return of 18%. The expected rate of return indicates the expected returns the bank is looking for the venture. It also indicates the risk associated with the product lines. So discounting the expected future free cash flows at the rate of 18% ( the expected rate of discount for the bank ) ,we get the discounted cash flows for the products to be the following :

• BIBLIOGRAPHY:
  
• Capital budgeting: financial appraisal of investment projects
  Dayananda, Don. Cambridge: Cambridge University Press, 2002
  
• Corporate and divisional influence in capital budgeting: a study of corporate and divisional capital budgeting practice in large UK companies
  Mills, Roger W. London: Chartered Institute of Management Accountants, 1987
  
• Management accounting, organizational theory and capital budgeting: three surveys
  Scapens, Robert W. (Robert William), 1946. London: Macmillan, 1984