Capital Budgeting Techniques For Investment Decision Making

Capital Budgeting Techniques

Net Present Value= $ -0.465

Internal Rate of Return= 3.85%

Payback Period= 3.10 Years

Accounting Rate of Return= Average Annual Accounting Profit

Average Investment

Average Profits = 0.012 + 0.008 + 0.603 + 0.327 + 0.483   =$ 0.286

                                                               5

Average Investment= salvage value + 0.5 (Initial investment – salvage value)

                                     = .0240 + 0.5 (2.40-.0240)

                                     = $ 1.32

Accounting Rate of Return= 22%

Profitability Index =

= 1.935

    2.40

= .81

• Analysis 

The net present value of the project is negative ($ -0.465) and it indicates that the project will not generate sufficient cash inflows to recover its cash outflows and hence it must not be accepted (Bierman & Smidt, 2012).

The payback period of 3.10 years whereas DCL has a policy of repaying its capital investment within 2.50 years. Payback of 3.10 years signifies that the project will recover its initial outlays in 3.10 years and after this period it will start generating returns. Hence, it must not be accepted (Kahraman, 2001).

The internal rate of return of the project is 3.85% which is quite lesser than the required rate of return of the project i.e. 12.50% and hence it must not be accepted as IRR is the discounting rate at which the project has no profit and no loss (Ryan & Ryan, 2002).

The accounting rate of return of the project is 21.70% which is greater than the project’s desired rate of return. Hence, the project can be accepted from the standpoint of ARR.

Lastly, the profitability index of any project must be at least one for its acceptance by the managers. However, in the present project, the PI is 0.81. Hence, the project must not be accepted from the viewpoint of profitability index (Graham & Harvey, 2002).

The four out of five capital budgeting techniques which are mostly used to evaluate the appropriateness of capital investment decision are providing unfavourable results for the acceptance of the project. Those techniques are NPV, IRR, Payback period and Profitability index.

The treatment of loan repayments and salvage value of the project equipment is explained as below:

The loan instalment includes both interest and principle element. The entire instalment amount of the loan per year is deducted from the cash flow amount of each particular year to reach at the amount of net cash flows. However, for the purpose of calculation of Accounting rate of return, where net profits are required to be taken into consideration, only the interest element was deducted from the cash flows and not the principle amount as it is a capital amount and need not be deducted from the profits of the company. Salvage value which is 10% of the initial investment in the new equipment will be treated as cash inflow of year 5, i.e. end of project’s life. Hence, for the calculation of net cash flows such inflow will be added to the cash flows of 5^th year. However, since the question is silent on the tax rate applicable on the company it is assumed that the company is operating in tax free zone and hence it is not required to pay any tax obligations (Drake, 2006).

Net Present Value (NPV)

Therefore, the tax treatment of both interest payments and capital gain ($0.240 – $0.190= $0.50) is to be ignored (Ross, Westerfield & Jaffe, 1990).

Workings:

The tax benefits of depreciation is ignored in the present case as there is no tax rate given and it is assumed that there is no tax imposed on the company.

First of all, the rate of depreciation as per Straight line method is calculated by dividing the whole percentage by years of useful life i.e. years. This provided SLM depreciation rate of 25% p.a. This rate was then doubled as per the requirement of method of depreciation given in the question. The doubled rate of depreciation i.e. 50% was applied according to the diminishing balance method of depreciation.

Table showing calculations of cash flows after tax:

The net present value of the project is positive i.e. $ 5112435.71 and hence the project must be accepted.

Part 2: Sensitivity Analysis:

The sensitivity of the project on sales revenue will have to be examined in two parts as the sales figure covers two elements that are: the selling price per unit and the number of units. If change is made in any of these input variables, the net present value of the project will be adjusted accordingly. Following range of selling price and selling units will be taken to show the project’s sensitivity to the sales revenue.

• Sensitivity to change in number of units sold

With each 5% change in original sales units’ i.e.143000, the NPV will change as follows

• Sensitivity to change in unit price

With each 5% change in unit selling price i.e. $ 99, the NPV will change as follows

• Sensitivity to change in Cost of capital

With each 5% change in original cost of capital i.e. 12.50%, the NPV will change as follows

Scenario analysis considers 3 scenarios of the project situation. These are: worst case, base case and best case. Worst case is the case where the situations under which the project operates are unfavourable and best case is the case where the situations under which the project operates are favourable. In case of base case the project is operated under normal situations.

In all these cases the net present values of the projects are determined and analysed using the probability of all the three potential cases, under scenario analysis. Therefore, scenario analysis gives broader insights to the project manager about the effect of changes in the situations or parameters on project’s NPV. However, the sensitivity analysis undertakes only one input variable in one to check the project’s sensitivity. It is not capable of showing the impact of change in overall situation on the project’s net present value (Horngren et al., 2002). Scenario analysis, on the other hand takes into account all the factors in one go to determine the impact of changes on project’s returns. Hence, it gives additional insights while dealing with the probability of all the possible cases (Meier, Christofides & Salkin, 2001).

Risk is the uncertainty of returns to be generated from the project due to fluctuations resulting from factors like change in economic growth rate, inflation rate, demand of units to be sold etc. (Alessandri, Ford, Lander, 2004).  In the present case the risk is priced on the basis of sensitivity analysis where the sensitivity of the project is analysed with respect to change in unit selling price and the number of units sold and also the change in cost of capital. Also, to check the risk of project, its net present value is also determined. The positive net present value of the project shows that project is capable of generating sufficient returns for the investors. In the present case, the NPV of the project is positive and hence it shows that the project will generate good amount of returns. Hence the project manager must be confident enough that its returns are in accordance with the risk of the project due to fluctuating cash flows.

References:

Alessandri, T.M., Ford, D.N., Lander, D.M., Leggio, K.B. and Taylor, M., 2004. Managing risk and uncertainty in complex capital projects. The Quarterly Review of Economics and Finance, 44(5), pp.751-767.

Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.

Drake, P.P., 2006.Capital budgeting techniques: < www. fau. edu/~ ppeter/fin3403/module6/capbudtech. Pdf >

Graham, J. and Harvey, C., 2002. How do CFOs make capital budgeting and capital structure decisions?. Journal of applied corporate finance, 15(1), pp.8-23.

Horngren, C.T., Bhimani, A., Datar, S.M., Foster, G. and Horngren, C.T., 2002. Management and cost accounting. Harlow: Financial Times/Prentice Hall.

Kahraman, C., 2001. Capital budgeting techniques using discounted fuzzy cash flows. In Soft Computing for Risk Evaluation and Management (pp. 375-396). Physica, Heidelberg.

Meier, H., Christofides, N. and Salkin, G., 2001. Capital budgeting under uncertainty—an integrated approach using contingent claims analysis and integer programming. Operations Research, 49(2), pp.196-206.

Ross, S.A., Westerfield, R. and Jaffe, J.F., 1990. Corporate finance (Vol. 2). Homewood: Irwin.

Ryan, P.A. and Ryan, G.P., 2002. Capital budgeting practices of the Fortune 1000: how have things changed?. Journal of business and management, 8(4), p.355.

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