7.1 Initial Steps of Krakatau Steel’s Financial Analysis

 

The three most important lines of balanced sheets are assets, liabilities and equities (Ross, 2021). Figure 1-3 reports the balanced sheet of Krakatau Steel Inc as the chosen manufacturing company for the most recently reported 5 years data (Journal, 2020).  Figure 1 mentioned the information that trends of the total asset increase or have positive growth percentage from 2016 to 2017, decrease or have linearly negative percentage from 2017-2019, and increase or have positive growth percentage again in the year of 2019 to 2020. The values of relatively equal size of the total asset which can be seen in the blue right tabular figure and the amount difference are in the year of 2016 and 2017.

Figure 1. Krakatau steel’s assets obtained from balanced data (Journal, 2020)

 

Figure 2 mentioned the information that trends of the total current liabilities increase or have positive growth percentage from 2016 to 2019, decrease or have linearly negative percentage from 2019-2020. The values of relatively equal size of the total current liabilities which can be seen in the blue right tabular figure and the amount difference are in the year of 2016 and 2017.

Figure 2. Krakatau steel’s current liabilities obtained from balanced data (Journal, 2020)

Figure 3 mentioned the information that trends of the total equity increase or having positive growth percentage from 2016 to 2017, decrease or having linearly negative percentage from 2017-2019, and increase or having positive growth percentage again in the year of 2019 to 2020. The values of relatively equal size of the total equity which can be seen in the blue right tabular figure and the amount difference are in the year of 2016 and 2017.

 Figure 3. Krakatau steel’s total equity obtained from balanced data (Journal, 2020)

The three most important lines of income statements are revenues, expenses and net profits. Over all expenses, I choose SG&A expenses as the most important one. The following figure reports the income statement of Krakatau Steel Inc as the chosen manufacturing company for the most recently reported 5 years data (Journal, 2020). Figure 4 mentioned information that the trends of the sales /revenue from 2016 to 2018 is linearly increasing and from 2018 to 2020 is linearly decreasing with subsequent positive growth until 2018 and negative growth afterwards. The values of relatively equal size of revenues are in the year of 2020 and 2017 with the difference in the amount of (19684467 – 19390485 = 293982) millions of IDR. The SG&A expenses get more and more expensive from 2016 to 2019 also depicted in the SG&A’s positive growth until the corresponding year which continues to fall down or negatively grows in the next year 2019 to 2020. The values of relatively equal size of SG&A expenses which can be seen in the blue right tabular figure and the amount difference are in the year of 2017 and 2018.     

Figure 4. Sale revenues and SG&A expenses obtained from Krakatau Steel’s Income Statement (Journal, 2020)

Figure 5 mentioned the information that the trends of the net income increase or have positive growth percentage from 2016 to 2017, decrease or have linearly negative percentage from 2017-2019, and increase or have positive growth percentage again in the year of 2019 to 2020. The values of relatively equal size of net income which can be seen in the blue right tabular figure are in the year of 2016 and 2018.     

Figure 5. Net income obtained from Krakatau Steel’s Income Statement (Journal, 2020)

Overall, the steps in completing a thorough financial analysis can be performed by using some ways including absolute decreases and increases, negative and positive growth percentages  of an item periodically as we did in the above analysis. Therefore the next step should be the percentage of the single items to the aggregated total and the so-called financial ratios (Boundless, n.d.)

References

Ross, S. (2021, October 14). The main focus points when analyzing a balance sheet. Investopedia. Retrieved October 19, 2021, from https://www.investopedia.com/ask/answers/050615/what-items-balance-sheet-are-most-important-fundamental-analysis.asp. 

Journal, W. S. (2020). Kras.id | Krakatau Steel annual income statement - WSJ. The Wall Street Journal. Retrieved October 19, 2021, from https://www.wsj.com/market-data/quotes/ID/XIDX/KRAS/financials/annual/income-statement. 

Boundless. (n.d.). Boundless accounting. Lumen. Retrieved October 19, 2021, from https://courses.lumenlearning.com/boundless-accounting/chapter/next-steps-in-financial-statement-analysis/. 

 

6.3 Methods Of Capital Budgeting Decision (Rate and Profit or Loss Sharing Ratio Comparison)

 

The three main capital budgeting tools usually performed are NPV, IRR and Payback period. In more detail definition,    

1.      NPV (Net present value) is the difference between cash outflow and cash inflow’s present values over a period of time. A present value of a time period is the multiplication between present value factor (PV = 1/(1+r)ⁿ, r = rate of return, n = periods) and total cash in or out of that period. And the net present value is the sum of all available periods. Positive NPV means that, in present dollars, anticipated costs are less than projected earnings. In other words, Positive NPV indicates profitable investments and Negative NPV indicates unprofitable ones (Fernando, 2021).

2.      IRR (Internal rate of return) is a used metric for financial analysis to do the estimation of potential investment’s profitability. In a discounted analysis of cash flows, it is a rate of discount making the NPV of all cash flows as follows, (Fernando, 2021).

In general, higher IRR means better investment based on the definition to make total NPV quickly go to zero (Ganti, 2021). General excel formula to calculate the IRR can be written as : =IRR(Total cash at year 0: Total cash at year n, initial guess value)

3.      Payback period is the required amount of time for the investment cost recovery. In other words, it is the time for the investment to reach the Break Even Point (BEP) (Kagan, 2021). In the technical excel sheet, the calculation uses the fact that the payback period is the time at exactly zero cumulative cash flow. If the cash flow data show no zero cumulative cash flows then we can use the linear regression technique to find the linear equation between two points consisting of the last negative and the first positive cumulative cash flows. In detail, the required payback period is the year on the x axis where cumulative cash flow is exactly zero at the y axis.   

 

The best and the least information can be based on the critics to the above theories. The critics to the net present value (NPV) and (Internal rate of return) IRR which are closely related to the TVM (Time value of Money) are as follow :

1.    Due to the above  present value factor in relation to the future value, the theory of NPV closely related to disconto theory let money rely on the time period. Adiawarman in (Ilyas, 2017) mentioned The TVM concept is intervention to the biological concept in economy, making money as a biological cell which can grow by itself using the formula : Pb = Po (1+g)^t, where Pb is growing cell, Po is initial cell, g is growing factor and t is time. The adopted financial formula is FV = PV(1+r)^n . The critic is that money can not be made similar with biological cell since it’s spread must only be generated to be as an exchange to the goods and service transaction and money must not be made as commodities.

2.    Time value of money (TVM) is defined as “a dollar today is worth more than a dollar in the future because to get a return a dollar today can be invested”. This means TVM always predicts positive return, while in contradiction,  Adiwarman in (Ilyas, 2017) said this definition is not accurate since every investment always has probability to get negative, positive or even no return. 

3.    The IRR (Internal Rate of Return) and NPV using the required rate of return introduce the concept of rate which is in contradiction with the concept of profit/loss sharing due to the fact that all investments and businesses have profit or loss probabilities.

In conclusion the last concept of payback period and even the NPV and IRR becomes the least information if the present cash flow data are sourced from the required rate of return and becomes the best information if the present cash flow data are sourced from the profit or loss sharing ratio (Ruminta,2020). 

Additional Note :  Considering the unstable value of money, further available choices of more stable concepts of capital budgeting analysis are using golds such as those in the Hamdi’s model (Gold Value Method (GVM), Gold Index (GI) and Investible Surplus Method (ISM) ) (Hamdi at all , 2021)     

References 

Fernando, J. (2021, October 13). Net present value (NPV). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/n/npv.asp.  

Fernando, J. (2021, October 13). Internal Rate of Return (IRR). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/irr.asp.  

Ganti, A. (2021, October 13). Internal Rate of Return (IRR) rule. Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/internal-rate-of-return-rule.asp.  

Kagan, J. (2021, October 13). What is the payback period? Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/p/paybackperiod.asp.  

Ilyas, R. (2017). Time value of money Dalam Perspektif Hukum islam. AL-'ADALAH, 14(1), 157. https://doi.org/10.24042/adalah.v14i1.1991

Ruminta, D. (2020, April 1). Analisis Perbandingan Perhitungan Kelayakan finansial Konvensional Dan syariah. Jurnal ECODEMICA. Retrieved October 15, 2021, from https://ejournal.bsi.ac.id/ejurnal/index.php/ecodemica/article/view/7603. 

Agustin, H., Azmi, N., Armis, & Asril. (2021). Analisis Pengembangan usaha nenas Sakinah Berdasarkan Aspek Keuangan konvensional dan syariah (Hamdi’s method). Jurnal Tabarru': Islamic Banking and Finance, 4(1), 219–230. https://doi.org/10.25299/jtb.2021.vol4(1).6749 

 

6.2 Conventional Capital Budgeting Analysis of A Manufacturing Company (Being corrected)

 

Capital budgeting is the process of undertaking the evaluation of potential major investments or projects. Some examples of projects that require capital budgeting before approval or rejection can be the big investment in outside ventures or new plant construction (Kenton, 2021). In the case of a manufacturing company being concerned, the company is evaluating two new equipment options to be chosen as a new product suitble for the production enhancement. The company’s manager requested the finance and accounting department to give recommendations on how to choose the best option based on capital budgeting analysis.

The three main capital budgeting calculations to be performed are NPV, IRR and Payback period. In more detail explanation, in relation to the available data of the problem, they can be defined and articulated as,    

1.      NPV (Net present value) is the difference between cash outflow and cash inflow’s present values over a period of time. In my detail calculations, a present value of a time period is the multiplication between present value factor (PV = 1/(1+r)ⁿ, r = rate of return, n = periods) and total cash in or out of that period. And the net present value is sum of all available periods. Positive NPV  means that ,in present dollars, anticipated costs are less than projected earnings. In other words, Positive NPV indicates profitable investments  and Negative NPV indicates unprofitable ones (Fernando, 2021).

2.       IRR (Internal rate of return) is a used metric for financial analysis to do the estimation of potential investment’s profitability. In a discounted analysis of cash flows, it is a rate of discount making the NPV of all cash flows  (Fernando, 2021).

0 = NPV = sum_t=1^t=T (C_t ​/(1+IRR)^t  - C₀ )

​where :

C_t ​ = Net cash inflow during the period t

C₀ = Total initial investment costs

IRR=The internal rate of return

t=The number of time periods​
 

In general, higher IRR means better investment based on the definition to make total NPV quickly goes to zero (Ganti,2021). In this research, general excel formula to calculate the IRR can be written as : =IRR(Total cash at year 0: Total cash at year n, initial guess value)

3.      Payback period is the required amount of time for the investment cost recovery. In other word, it is the time for the investment to reach the Break Even Point (BEP) (Kagan , 2021 ). Our detail calculation purpose in the excel sheet uses the fact that the payback period is the time at exactly zero cumulative cash flow. In the two options, no zero cumulative cash flows are available. Therefore, we use the linear regression technique to find the linear equation to find the Payback period which is the year as the x axis at which cumulative cash flow is exactly zero at the y axis.     

 

Based on the above definition and articulation, further summary of calculation can be done by the following table,

Required rate of return for both options

0.08

For Option 1 :

Therefore, for Option1 :

Present value = total cash * PV (Present Value) factor

NPV = sum(B14:I14) = $ 56470.64163

IRR = IRR(B10:I10,0.1072) = 18% ;  (Note : 0.1072 is a guessing value )

Payback Period = 4 years 10.13114754 months

(the x value =295500/61000 =4.844262295 years,  for y value = $ 0 (Cumulative cash flows)  at the equation of y = 61000x -295500)

For Option 2 :

Therefore, for Option 2 :

Present value = total cash * PV (Present Value) factor

NPV =SUM(B29:I29) = $ - 9336.578665

IRR = =IRR(B25:I25,0.1072) = 9% ;  (Note : 0.1072 is a guessing value )

Payback Period = 5 years 9.401055537 months

(the x value =597225/103265 = 5.783421295 years,  for y value = $ 0 (Cumulative cash flows)  at the equation of y = 103265x -597225)               

Based on the calculation results, the meaning of the option 1 NPV value > 0 was previously discussed as indication of profitable investment. While the option 2 NPV value < 0 indicates unprofitable investment. IRR option 1 (18%) which is greater than IRR option 2 (9%) indicates that the IRR of option 1 is better than that of Option 2 since the higher IRR is the better investment. Moreover, the payback period of option 1 with the amount of 4 years 10.13114754 months is faster than the payback period of option 2 with the amount of 5 years 9.401055537 months.   

In conclusion, based on the above NPV, IRR, and payback period comparisons between the two options, the manufacturing company should choose the option 1 as a new equipment product suitable for the production enhancement. The analysis of preferring the option 1 is also proven right by considering the other factors that even though the price of the option 1 with no salvage value is more expansive than option 2 with salvage value of $10,000, materials, labors and maintenance costs of the option 1 is  cheaper than those of the option 2. Therefore, the option 1 is the best choice.

Note : This conventional calculation was performed using required rate of return. In the Islamic perspective, the cash flow data are based on profit and loss sharing. 

References 

Kenton, W. (2021, October 13). What is capital budgeting? Investopedia. Retrieved October 14, 2021, from https://www.investopedia.com/terms/c/capitalbudgeting.asp. 

Fernando, J. (2021, October 13). Net present value (NPV). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/n/npv.asp. 

Fernando, J. (2021, October 13). Internal Rate of Return (IRR). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/irr.asp. 

Ganti, A. (2021, October 13). Internal Rate of Return (IRR) rule. Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/internal-rate-of-return-rule.asp. 

Kagan, J. (2021, October 13). What is the payback period? Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/p/paybackperiod.asp. 

 

6.1 Capital Budgeting Risks

 

The term risk in this case is the uncetainy degree associated wih an asset’s returne. There exist many kinds of risks in capital budgeting, including project specific, market, international, corporate, industry specific and stand-alone risks (Anonimus, n.d.). In more detail explanation, Project specific risk is the relatively specified risk for a certain project. The risk can happen as a result of discount rate or cash flow estimation error done by deficiency in management leading to unfavorable situation that the actually realeased cash flow become less than the projected one (Sarav and Sarav, 2017). Market specific risk results from macroeconomic factors rates of interest and inflation. This kind of risk significanlty happen in the time of unstable or weak economical condition. Once the economic situation is down, product demand decreases, potentially creating unprofitable project (Rodeck, 2016). International risk exposure happen as a result of involved or shared capital budget projects between companies across countries, which entail exchange rate and political project risks. Political or civil unrest potenially caused entirely lost investment if the ongoing project is being established in a country of unstable political structures (Rodeck, 2016). Corporate risk can be defined as risk of organization suferring from declines in earning and revenues as a result of unfavorable events affecting the organization or corporation (Anonimous, 2020). Industri specific risk means the risk affecting the sector of industry where the companies the runs the business. The last one is he stand alone risk which has association with a single company or unit of operation, asset or division of a company in its opposition to a well diversified and larger portofolio (Chen, 2021).             

Based on the above definition, the most significant risks are project, market and international risks. The specific reasons can be based on the above definition that the market and project risk have a close relation each other. Existing interest based investment will give heavy usury that really makes the project unprofitable. The project cost will increase so much if the established method only takes interest not based on profit and loss sharing, the poor will get poorer and the rich will get richer. Therefore, the investment system should be chosen if not only profit but also loss will be shared between the investors and business contributors.  In relation to the product if the market demand is down, the project will be considerably unprofitable due to the fact that their production rates will go down proportionally with decreasing demands. If the projects of making the massive product are still done as usual. Many products will remain in the inventories for a long period of time. This is unfavorable since the products might reduce the original reliability and quality. The third risk that mostly contribute to the global economic problem is the international risks. This risk actullay happen on the shared exporting and importing projects on very high demand such as the current covid 19 vaccines. The rejection of some citizens to take imported vaccines from specific countries due to the existing hatred or kinds of sensitive issues making them massively reject the national and vaccination program with the result that the country’s investment for the national and world herd immuniy will be difficult to achieve.   

 

References

Anonimous. (n.d.). Boundless finance. Lumen. Retrieved October 11, 2021, from https://courses.lumenlearning.com/boundless-finance/chapter/the-relationship-between-risk-and-capital-budgeting/.   

Sarav, & Sarav Author. (2017, June 4). Risks in Capital Budgeting. Mytypings.com. Retrieved October 11, 2021, from http://mytypings.com/risks-in-capital-budgeting/.  

Rodeck, D. (2016, October 26). What factors increase the riskiness of a capital budgeting project? Small Business - Chron.com. Retrieved October 11, 2021, from https://smallbusiness.chron.com/factors-increase-riskiness-capital-budgeting-project-15829.html. 

  Anonimous. (2020, September 8). Guide to corporate risk in capital budgeting - WELP magazine. Welp Magazine - Business Strategy, Executive Software, Growth Hacking and more... Retrieved October 11, 2021, from https://welpmagazine.com/guide-to-corporate-risk-in-capital-budgeting/.  

AbuJubara, A. A. (2020, March 16). Risks Associated with Capital Budgeting. Amjed online . Retrieved October 11, 2021, from https://amjedonline.com/2020/03/16/risk/.  

Chen, J. (2021, May 19). What is standalone risk? Investopedia. Retrieved October 11, 2021, from https://www.investopedia.com/terms/s/standalone_risk.asp.