Capital Budgeting Techniques Used By Northern Lights Inc

Calculation of NPV

This report highlights the capital budgeting techniques used by Northern Lights Inc in order to evaluate its new production line in efficient bulb markets. The most important method used in the report is Net Present value method which determines the overall profitability of the project in each and every scenario. In the later part, the report also focuses on the difference between nominal and real cash flows, taking into account the nominal and real discounting rate. Further, sensitivity analysis of the project has also been done in which the NPV of efficient bulb is tested for different sales scenarios and inflation impact on production cost and selling price. Also, for discounting rate of return the WACC of the company has been calculated and changes in the same are shown in the later part of the report. In the end, a conclusion is provided that provide insights about the profitability of the project to the company’s executives and VPs and help them in taking decisions regarding making investment in the project.  

For the base case scenario, the total outflow made by the company is S545000. Considering the impact of inflation at both the selling price and cost of production, the net present value of the project is $ 73,103.77. This means that the project will be profitable in coming years as it has high and positive NPV. Also, as per the decision criteria of this method, proposals having high and positive net present value are considered to be profitable and favorable for the company (Baker, Jabbouri and Dyaz, 2017).

Another method which is used to measure the viability of the project is payback period. It is the simplest technique used as it determines the amount of time required by the proposal to recover the initial investment or cash outlay (BiermanJr and Smidt, 2014). The payback period in case of Northern Lights is 3 years which means out of the entire life of 4 years, the efficient bulb project will take 3 years to recover the initial cash outflow of $545000 made by the company. However, the method does not take into account the present values of cash flows.

Real cash flows are the ones which do not consider the impact of inflation in their calculation and are discounted at real required rate of return. On the other hand, nominal cash flows consider the future amount of cash flows by taking into account the impact of inflation. It considers the inflation in costs and revenue while calculating the cash flows and NPV of the project. Furthermore, a particular formula is applied to calculate the nominal discounting rate as the weighted average cost of capital is considered as the real discounting rate (Daunfeldt and Hartwig, 2014).

NPV at real discounting rate

It can be seen that the present value of the cash flow in year four is $139,627.40 and the net present value is negative at -$42,971.86. This was because of the high production cost as compare to the selling price.

NPV at nominal discounting rate

Requirement 2

While discounting at nominal rate, the NPV of the project turn out to be negative at -$2587.75. This was due to the fact that impact of inflation has been taken into account at time of converting the real rate to nominal. This has increased the discounting rate from 11% to 16.90% due to which the present value in year four is $149282.1195. It can be observed that from both the method, the present value for the cash flow of year 4 is not same because of the change in discounting rate.

The breakeven point in case of capital budgeting is the point where the NPV of the project is zero. It means the present value of cash inflows will be equal to present values of cash outflows. The breakeven is that situation where the company is in no profit and no loss.

• The price per bulb at year 0 should be $1.912505 where the NPV of the project is zero. If the price is lower than this the, NPV will become negative and if the company sell products at more than the price of breakeven, it will earn profit as the NPV will be positive.

• The production cost at zero level should be $ 1.59 in order to break even the project. Keeping the inflation in mind, if the cost of production is this then the NPV of the project will be zero. Cost more than $1.59 will lead to negative NPV while less than it will make the net present value positive.

• The below table shows the break even sales units at which the project’s NPV will be zero. If Northern Lights Inc produces such number of units then the present value of its cash inflows will be equal to cash outflows.  

• If the cost of production increased at the inflation rate of 5% instead of 2.5%, then the NPV will turn out to be -$26.

• If the selling price increased at the inflation rate of 2.5% while the cost increased at rate of 5%, then the project will be no more profitable as it report its NPV at $96,114.49.

Sensitivity analysis is also known as What-if analysis and is conducted to know that how the fluctuations or changes in the input variables impact the overall outcome or result. In other words, it is explained as how the different values of independent variables affect the dependent variable under a provided set of assumptions. The analysis is done to note the profitability of the project under different circumstances such as increase or decrease in selling price, changes in interest rates and others (Borgonovo, 2017). 

In case of Northern Lights, three input variables are considered to perform the sensitivity analysis. They are the machinery salvage value in the year four, sales of year one and the discounting rate. An increase and decrease of 10%, 20% and 30% has been shown in all these three variables and the impact of NPV has been noticed.

• Machinery salvage value

The above table record the increase and decrease in salvage value from 10% to 30%. It can be observed that if there is an increase in the salvage value with respective percentages than the NPV of the project will increase from $79,691.08 to $92,865.70. On the other hand, the decrease in the same will make the NPV to fall from $66516.46 to $53341.84. Thus, it is interpreted that the value must increase in order to generate high and positive NPV.

• Sales units

The unit sales considered in base case have already increased at the rate of 2% year on year. 10% in increase in the same will result in high NPV of $124,969.61. Similarly, a rise of 20% and 30% in first year sale units will make the NPV to increase at $176,835.44 and $228,701.27 respectively. In contrast to it, decrease in the units with the respective percentages will make the NPV to fall initially and then gradually it become negative. Thus, it can be said that the NPV and sales has a positive correlation as it rise in one will increase the other and vice-versa (Venkatesh and Gugloth, 2017).

• Discounting rate

The required rate of return used in calculation of cash flows is the weighted average cost of capital of Northern Lights Inc which appears to be at 11%. It can be observed from the table that as and when the rate increased from 12.10% to 14.30%, the NPV declines from $57,755.40 to $28,827.64; lower than the NPV of base case scenario. In contrast to it, the respective decrease in the rate will increase the NPV from $89,084.24 to $123,081.70. Hence, it is concluded that discounting at the lower rate will make the project more profitable as the rate and NPV are inversely related.

Requirement 3

Scenario analysis is another type of technique used for measuring the outcome of a particular investment in different scenarios. The sales manager of Northern Lights has provided three scenarios in which the demand of efficient bulb was high, low and average (Gotze, Northcott and Schuster, 2016). 

From the calculations, it is expected that the NPV of the entire project is $73,103.77 which also appears in base case that is when the demand is average. In the scenario, where the company faces low demand, the project become unprofitable as its NPV turn out to be negative at -$153,288.85. On the contrary, the scenario of high demand is considered to be the best case as the NPV is highest in that situation. It will be $299.496.39 if this situation occurs. The probability of occurrence of both the best and worst case is 0.25 while the base case has high probability at 0.5 which makes the expected NPV equal to the base case NPV. So it will advisable to the management to create an average demand of company’s product so that reasonable profits can be made.  

According to the CFO of Northern Lights, it has been noticed that the company’s competitors have high beta that is 50% more than the company’s beta. As a result is reflects high market risk. Currently Northern Lights have beta of 2 and if it increases the same by 50%, its will become 3 and also impact the cost of equity of the firm. The cost of equity will increase from 14% to 21% due to the rise in beta which eventually make the WACC to increase from 11% to 16%. With such upsurge, the NPV of the project fall to $11,955.77 from $73,103.77. This is because it lowered the present values of future cash flow which eventually impact its NPV. Thus, an increase in beta will lower down the NPV of the project (Shapiro, 2008). 

Conclusion and recommendation

From the above report, it is concluded that the company should perform its operations in base case scenario only as the inflation is taken into account and lower WACC will increase the profitability of the investment proposal. The company has low debt, which keeps its WACC low and reflects lower financial risk of the firm. Thus, it will be recommended to the company to go for the project and make investment in it as in natural circumstances, it prove to be profitable for the firm. 

References 

Baker, H.K., Jabbouri, I. and Dyaz, C. (2017). Corporate finance practices in Morocco. Managerial Finance, 43(8), 865-880.

BiermanJr, H. and Smidt, S. (2014). Advanced capital budgeting: Refinements in the economic analysis of investment projects. Oxon: Routledge.

Borgonovo, E. (2017). Sensitivity Analysis: An Introduction for the Management Scientist (Vol. 251). Switzerland: Springer.

Daunfeldt, S.O. and Hartwig, F. (2014). What determines the use of capital budgeting methods?: Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4),101-112.

Gotze, U., Northcott, D. and Schuster, P. (2016). INVESTMENT APPRAISAL. (2^nded.). New York: Springer.

Shapiro, A. C. (2008). Capital budgeting and investment analysis. India: Pearson Education.

Venkatesh, M. and Gugloth, D. (2017). A Review of Capital Budgeting Techniques. International Journal of Economics and Management Studies. Avaialbe at: https://www.internationaljournalssrg.org/IJEMS/2017/Special-Issues/ICEEMST/IJEMS-ICEEMST-P102.pdf

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