Evaluation Of A Capital Budgeting Project: Radiant Laundry Product Company

Discussion

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This particular assignment intends to evaluate the project by employing techniques of capital budgeting. Analysis of the project is done by answering the questions concerning the project. The radiant laundry product company is the leading producer of laundry detergent having two major product lines that is traditional power detergent and concentrated power detergent.  Project that is considered by the company is intended to involve in the production of new product that is a liquid detergent product called FAB. It is perceived by company that this product have advantage over the conventional detergent product in terms of better cleaning capabilities, reduced usage of detergent and easier to control and use. The packaging facilities new production equipment for the production of new liquid detergent are proposed to be sourced from two organizations that is Donnalley limited and Danforth limited. Several parameters that are associated with making investment in Donnalley limited are that the estimated life of investing in this particular project is ten years having an expected salvage value of $ 80000. The rate of depreciation assumed for the packaging and equipment facilities stood at 35% and the depreciation will be done on a reducing balancing basis. On other hand, investing in Danforth project would initially cost $ 1.3 million and this comprise of packaging facilities and equipment. This will help in reducing the cost of debt to $ 0.8 million compared to $ 1.5 million. The expected life of new equipment would be five years. The total life time of this particular project would be ten years.  All the questions answered below would be in conducting the in depth analysis of the projects that the company is seeking to undertake for producing the liquid detergent. However, in order to make investment in Donalley would require additional working capital of $ 100000.

Capital budgeting is the technique that is used by business enterprise or individual for big investment projects and it is used for evaluating whether a particular project undertaken is feasible enough to make investment in. there are two concepts involved in the analysis of the projects that is future or initial outlays that is expected for the acquisition of assets and expected flows of cash that is generated by assets utilization. There are two criteria of capital budgeting techniques or the investment appraisal tool that is discounted cash flow criteria and non discounting cash flow criteria (Alhabeeb, 2016).

Evaluation Techniques: Discounted and Non-Discounted Cash Flow Criteria

Evaluation of project is done by using both the criteria of tool of appraisal. The techniques used under the discounting cash flow criteria are net present value, profitability index and internal rate of return (Longin, 2016). On other hand, non discounted cash flow criteria make use of accounting rate of return and payback period as the appraisal tool.

For evaluating the investment projects, one of the well known methods is technique of net present value. The acceptance or rejection of project depends upon the figures of net present value. A positive value is usually indication of the fact that the project should be accepted and a negative value depicts that the project should be rejected. In this method, the present valuation of the future value of cash flow is computed by using an appropriate discounting rate. Another method of evaluation of project is internal rate of return that is the rate at which the net present value of project is zero. For the purpose of evaluation of project, it is required by investor to make comparison between the internal rate of return and the cost of capital of organization. Investors should make acceptance of the project if the cost of capital is lower than the internal rate of return (Balakrishnan et al., 2016). On other hand, the project should be rejected if the cost of capital is more than internal rate of return.

Profitability index is another discounted cash flow method that is used by investors to evaluate the project. It is a technique of investment appraisal that is obtained by dividing present value of future cash flow by the initial amount of investment made by business enterprises. This particular method of capital budgeting helps in ranking of the investment and it assist on deciding on the best investment that should be made. Investors should accept the project is the profitability index of the project is more than one and the project should be rejected if the profitability index is less than project. This is so because a positive value of profitability index is indicative of the fact that future cash flow present value of project is more than the initial amount of investment that is made. Moreover, there is loss of investment if the value of profitability index is less than one (Rossi, 2014). On other hand, if the value of profitability index is equal to one would indicate that the project is not generating any profits. Therefore, it is an analysis tool that would help investors whether they should undertake any particular project or not.

Evaluation of the Two Investment Projects

Payback period on other hand is an evaluation method that does not take into consideration the discounting factor. Payback is the time period that is taken by the project for recovering the initial amount of investment that has been made (Moffett et al., 2016). Moreover, it is used or measuring whether the project is inherent to risk and the tool is the indication of how certain the cash inflow of the project is. It provides Radian laundry Project Company with the quick picture of the amount of time that the initial amount of investment will be at risk.

Accounting rate of return is the rate that makes use of arithmetic mean of accounting income that is expected to be earned by the project to the average amount of investment made. It is obtained by dividing average accounting profit by average amount of investment that is made. Investors should accept the project if the accounting rate of return is greater than the required rate of return or cost of capital. It helps investors in deciding about making (Chung et al., 2015).

All the above techniques of capital budgeting are used by Radiant laundry Product Company for evaluating the project that they are seeking to undertake for manufacturing liquid detergent as it would require new equipments and production facilities.

The evaluation of the project of manufacturing liquid detergent seeks investment in two enterprises that is Donnalley limited and Danforth Limited. This particular question is about recommending the Radiant laundry company for purchasing packaging facilities and specialized equipment from either Danforth limited and Donnalley limited. Both the projects are evaluated using the techniques of capital budgeting.

Considering making investment in Donnalley project with the total initial amount of investment stood at $ 2000000. It can be seen that in the first two years of operation, the project has generated net operating cash flow of amount $ 464400 and $ 514500 respectively. The total amount of net operating profit has decreased initially from $ 356295 to $ 349692 in the first year of operation and eventually in reduced in the later year of operation. Project generated reduced profit of $ 349692 in the third year of operation to $ 347350 in the later year of operation.

Now, looking at the figure of net present value, it can be seen that net present value of project stood at -$ 191880. The internal rate of return of the project stood at 18.01% and the profitability index stood at 1.10. Based on the value generated for the project, it is inferred that project should be rejected. It can be seen that the net present value of project is negative. Furthermore, the profitability index is lower than one that is indicative of the fact that making investment in project will not be generating profit.

Making an Investment Decision

Now, looking at the figures of investment project made in Danforth Limited, it can be seen that the total amount of investment that is required to be made in the project stood at % 1300000. It can be seen from the figures depicted in the table that the net profit generated from the project is increasing initially from $ 409200 in first year of operation to $ 523800 in the fifth year of operation. Profit, on other hand has started reducing since seventh year of operation to $ 410800 and $ 399100 in the last year of operation. The net present value of the project computed stood at $ 432034 and the internal rate of return stood at 25.97%. Profitability index of project on other hand stood at 1.33 with payback period at 2.78. It is generated by the figures that net present value of project is positive and the value of internal rate of return is more than the required rate of return. Therefore, it is viable to accept the project. In addition to this, the payback period of the project invested in Danforth Limited is less compared to making investment in project Donnalley limited.

Now, the investment project made in Danforth Limited is evaluated by taking into account inflation factor. Here, the total amount of investment to be made in the project Danforth limited stood at $ 1300000 and the time taken for the project is ten years. It can be seen from the table that there is continuous increase in net profit and the net profit after taxation is also increasing continuously. There is much fluctuation in net operating cash flow as the value has initially increased to $ 513905 as against $ 409200. In later part of year, net profit has increased further to $ 553635 and again declined to $ 415790 respectively. For the computation of net present value, the discount rate that has been assumed by Radiant laundry Product Company stood at 15%. The net cash flow in this particular investment project is generating an increasing cash flow in the initial years of operation that is the cash flow generated stood at $ 409200 in first year of operation to $ 508788 in the fifth year of operation. The net cash flow on other hand declined to negative value to -$ 786095 in sixth year of operation. Reason is attributable to the fact that company is required to make investment again in sixth year of operation. After making investment, it can be seen that net cash flow stood at $ 553635 and the net cash flow initially reduced to $ 465790 and thereafter it reduced to $ 465790. The net present value of project stood at $ 481334 with a payback period of 2.74. On other hand, the internal rate of return of the project stood at 27.01% that is above the required rate of return. It can be seen that when considering the inflation factor, the net present value generated by project is higher compared to net present value when inflation factor is not accounted for. Moreover, the payback period of project stood at 2.74 as against 1.33 when inflation is not considered.

Conclusion

Therefore, from the analysis of above figures, it can be inferred that it would be profitable to make investment in Danforth limited. The reason is attributable to a positive net present value, lower payback period and higher internal rate of return (McLean & Zhao, 2014).

Based on the evaluation of the given projects, making investment in Danforth Limited is considered viable and hence, Radian laundry Project Company would consider making investment in this particular project. The cash flow table is prepared for the Danforth limited take into account several factors such as initial amount, terminal and operating cash flow.

The cost of market testing of $ 150000 is not included in the cash flow table for preparing cash flow value of the project Danforth limited. The reason is attributable to the fact that the cost of market testing is nit regarded as relevant costing factor in the computation the viability of the project. In addition to this, the interest expense is on fixed term loan at the rate of 10% for financing the project is not incorporated in the cash flow table. This is so because the interest rate has always been included in the cash flow table. Therefore, it is not essential to include the amount of interest expense in the cash flow table.

The amount of initial working capital investment of $ 100000 is not included in the preparation of cash flow table. The cash outflow of this particular amount as a part of capital investment is not worthy as this amount would always be in the liquid form and would never leaving the company. It is for this reason that this amount of working capital investment would not be included in the cash flow table preparation. On other hand, preparation of cash flow table would incorporate the requirement of annual working capital at the rate of 12%.

The items of erosion of sales from current laundry detergent project would be included in the cash flow table preparation. This is so because for ascertaining the net sales figures before and after the launching of new product can be determined by taking into consideration the figure of sales erosion.

Furthermore, it is required by business enterprise to include the annual cost of renting of $ 120000. This is so because it would help in identifying the actual amount of revenue that would be generated by business by using this particular space. The current excess plant facilities should be charged something during then project. For determination of the parameters for evaluating the competitiveness of this project with other projects, it is required to treat it as some outside project as the firm would be charged with the same amount if this particular space is rented by some outside firms (Young & Pagliari, 2017).

It can be seen from the above table that the chosen project for making investment is Danforth Limited. The payback period of this particular project stood at 2.78 when inflation is not considered. On other hand, when taking inflation into account, the payback period stood at 2.74. Based on this particular appraisal tool, it is feasible to accept this project as the payback period is lower compared to Donnalley project. Now, looking at the figure of internal rate of return, it can be seen that the rate stood at 25.97% and the rate is higher than the required rate of return of the project. Therefore, as per the acceptance criteria for internal rate of return, the project should be accepted. Now, looking at the figure of profitability index, it is depicted from the computation that the value stood at 1.37. The acceptance criteria of project for the profitability index are that the value should be more than one (Young & Pagliari, 2017). Since, the value of profitability index is more than one, the project should be accepted.

The answer derived in the question would be impacted if there is rejection of the FAB project as the competitor would introduce the new similar product. In addition to this, the acceptance or rejection of the project would depend upon the revised computed value. This is so because; the new value of the project would be computed by conducting several external and internal factors. Radiant laundry Product Company would be required to perform market research and determine different parameters that are considered relevant in determination of the net present value of project (Meyer & Kiymaz, 2015).

The table below depicts the sensitivity analysis that is computed by making the assumption that there can be deviation of estimated value by increasing or decreasing 20%. Under sensitivity analysis, the net present value of project is determined by considering the changes in the components of cash flow using the cost of capital at the rate of 15%.

The net present value is positive in the given cases. Net present value of project stood at $ 432024 when the discount rate is 15% and the net present value stood at $ 279214 when the discount rate is at 18%. On other hand, in all other scenarios, the net present value is positive at amount of $ 623196 at the rate of 12%, $ 815313 at the lower rate of 15% and 48735 at the rate of 15%. It can be seen that the value of net present value is highest at the discount rate of 15%.

Inflation rate is the external factor that is impacting the valuation of project. It can be seen from the preparation of cash flow table of the project that inflation is affecting the value of project. There is increase in value of net present value, payback period and internal rate of return by the rate of inflation is taken into account. If the inflation rate is considered to be at 3%, it can be seen that the net present value of project has increased to $ 481334, internal rate of return at 24.01% and the payback period of 2.74.

Therefore, from the above computed figures, it can be seen that the value of appraisal tools have been considerably impacted by the inflation factor. The change in the value is positive in the sense that net present value generated has increased by considerable amount. The estimates of revenue and cost are adjusted by considering the changes in inflation value. Outcome of capital budgeting is affected significantly by inflation factor and the real rate of return that is incorporated in the computation of the project value is affected by factor such as inflation. Inflation helps in determination of real cost of capital for the computation of the net present value, payback period and accounting rate of return (Montinari & Stracca, 2016). Since the cost of capital does not completely represent the real cost of borrowing the funds, analysis of capital budgeting is influenced by inflation. However, the result of impact of capital budget is affected by performing the analysis in a manner that helps in compensating the inflation. The exposure of requirement of working capital can be reduced during the inflation as the firms under situation would be under pressure to lower the net working capital amount by decreasing receivables and inventory.

From the analysis of information provided in the case study and the evaluation of answers generated from the given questions, it is recommended to Radiant laundry Product Company to consider making investment in project of Danforth Limited. This is so because making investment in this particular project is generating positive amount of net present value, higher profitability index and lower payback period compared to another project that is Donnalley limited. Moreover, it can be seen that when considering investment in Danforth project, company is taking into account the inflation factor. Incorporating the inflation factor in this particular project, it can be seen that inflation has resulted in generation of higher net present value and lower payback period that is regarded as feasible factor for analysis. Furthermore, the profitability index of this particular project is higher as against Donnalley limited project.

Conclusion:

From the analysis of the given case study, it can be inferred that it would be feasible for the company to consider making investment in Danforth project. Undertaking this project would help in generating profit for the business. This is so because it is expected that there will be increased sales of liquid detergent that would increase the overall profitability of the business.

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