Capital Budgeting Techniques used for evaluation
The current report would intend to evaluate the feasibility of a particular project by using the various capital budgeting techniques. Booli Electronics is the chosen organisation in accordance with the provided case study and it is identified as a manufacturer of electronic products in Carlton, Victoria, Australia. It has been further observed that the organisation generates maximum amount of revenue from a particular item, which is smart speaker and home assistant (SSHA). However, with the rapid advancements in technology, the prototype used to manufacture this item has become obsolete. Therefore, it mandates the need for the organisation to develop a new one for which it has estimated the revenues to be earned and expenses to be incurred. For critical evaluation of the project viability, this report would shed light on the various techniques of capital budgeting to undertake the investment decision in the context of Booli Electronics.
For arriving at the non-discounted payback period and other techniques of capital budgeting mentioned below, the following computations are made.
The above tables mainly depict the calculation of initial investment, net annual cash inflows and the values of the investment appraisal techniques. In case of non-discounted payback period, it is the method expressed in number of years when the cash flows generated would help in recovering the total initial investment (Almazan, Chen and Titman 2017). A project with a lower payback period is considered feasible, as the initial investment of the organisation is at risk for a shorter timeframe. In the provided case of Booli Electronics, the payback period is obtained as 2.09 years, which is lower than the economic life of the project of five years. Hence, this project could be considered feasible for the organisation.
In the words of Andor, Mohanty and Toth (2015), profitability index is a method, which aims to detect the association between the costs and benefits of the proposed project. It is computed by dividing the present value of future cash inflows by the initial outlay. A ratio of 1 is the lowest acceptable measure, as a value lower than 1 denotes the present value of the project is lower compared to its initial investment (Rossi 2015). In this case, the profitability index is obtained as 1.65, which implies the viability of the project for Booli Electronics.
As commented by Burns and Walker (2015), internal rate of return helps in evaluating the project attractiveness and if it is higher than the required rate of return, the project is profitable and vice-versa. For Booli Electronics, the internal rate of return is obtained as 35.07%, which is more than the required rate of return of 12%. This implies that the project is feasible for the organisation in terms of investment decisions.
Payback period
Net present value helps in determining how profitable a project is in terms of monetary returns opposed to the investment made. A positive and higher value is always favourable, since greater returns are expected to be earned from the investment and vice-versa (De Andrés, De Fuente and San Martín 2015). In this case, the net present value is obtained as $37,847,147.77, which is a positive and higher value; thus, denoting the feasibility of the project.
For analysing the sensitivity in NPV, the selling price per unit and variable cost per unit are changed. Two cases are considered, which are described as follows:
Increase in selling price and variable cost by $10 per unit:
According to the above tables, it could be found that the rise in price per unit has resulted in net present value of $37,266,327.92, which is lower than the value obtained in the actual case scenario $37,847,147.77. However, it is still providing positive and higher return, since adequate cash flows are expected to be generated (Hall and Sibanda 2016).
Decrease in selling price and variable cost by $10 per unit:
According to the above tables, it could be found that the fall in price per unit has resulted in net present value of $37,409,596.15, which is lower than the value obtained in the actual case scenario $37,847,147.77. However, it is still providing positive and higher return, since adequate cash flows are expected to be generated (Johnson and Pfeiffer 2016). It is noteworthy to mention that if the price per unit is reduced, Booli Electronics would be able to earn more profit than in the case of increased price per unit.
For analysing the sensitivity in NPV, the sales volume is changed. Two cases are considered, which are described as follows:
Increase in quantity sold by 10,000 units:
If Booli Electronics decides to sell additional 10,000 units per year, it could be observed that the net present value of the project would be $46,406,685.16, which is significantly higher than the value obtained in the actual case scenario $37,847,147.77. Thus, profit level is expected to increase further; however, the market demand is to be taken into consideration before implementing the change (Johnson, Pfeiffer and Schneider 2017).
Decrease in quantity sold by 10,000 units:
If Booli Electronics decides to minimise 10,000 units per year, it could be observed that the net present value of the project would be $28,253,666.27, which is significantly lower than the value obtained in the actual case scenario $37,847,147.77. Thus, profit level is expected to decline significantly. Hence, it could be stated that the net present value is more sensitive to the change in sales volume rather than the change in price per unit (Johnson, Pfeiffer and Schneider 2017).
Profitability Index
Based on the above evaluation, it could be stated that all the investment appraisal techniques used to evaluate the viability of the project for Booli Electronics have provided positive signal. Even the changes in the price per unit and sales volume would fetch positive and profitable returns for the organisation. Therefore, it is advised to the management of Booli Electronics to proceed ahead with the project, since it would maximise its overall return on investment.
It could be identified that the major revenue producing item for Booli Electronics is the SSHA and hence, improvement in this model through additional investment might minimise the sales revenue of the organisation from other models. In such situation, two options need to be taken into consideration (Robinson and Burnett 2016). Firstly, it needs to be checked whether the profit generated from the new SSHA would be able to offset the fall in revenue from other models. Secondly, if the overall sales revenue of the organisation is decreased, it needs to consider raising the sales volume, as higher sales would raise its revenue generating capacity (Rossi 2014). In that case, the analysis needs to be made by considering the other models that Booli Electronics sells in the market.
Conclusion:
The above discussion makes it evident that the new SSHA would be highly profitable for Booli Electronics, as the return on investment would be maximised. This is validated by using the several investment appraisal techniques like payback period, internal rate of return, profitability index and net present value. Even the sensitivity analysis conducted implies that the organisation could make profits from the implementation of this new model. However, it needs to take into consideration the market demand and other models, as any change in these two aspects might have significant impact on the business profitability of Booli Electronics.
References:
Almazan, A., Chen, Z. and Titman, S., 2017. Firm Investment and Stakeholder Choices: A Top?Down Theory of Capital Budgeting. The Journal of Finance, 72(5), pp.2179-2228.
Andor, G., Mohanty, S.K. and Toth, T., 2015. Capital budgeting practices: A survey of Central and Eastern European firms. Emerging Markets Review, 23, pp.148-172.
Burns, R. and Walker, J., 2015. Capital budgeting surveys: the future is now.
De Andrés, P., De Fuente, G. and San Martín, P., 2015. Capital budgeting practices in Spain. BRQ Business Research Quarterly, 18(1), pp.37-56.
Hall, J.H. and Sibanda, T., 2016. Capital Budgeting Practices: An Empirical Study of Listed Small en Medium Enterprises. Corporate Ownership & Control, p.200.
Johnson, N.B. and Pfeiffer, T., 2016. Capital budgeting and divisional performance measurement. Foundations and Trends® in Accounting, 10(1), pp.1-100.
Johnson, N.B., Pfeiffer, T. and Schneider, G.T., 2017. Two-Stage Capital Budgeting, Capital Charge Rates, and Resource Constraints.
Robinson, C.J. and Burnett, J.R., 2016. Financial Management Practices: An Exploratory Study of Capital Budgeting Techniques in the Caribbean Region.
Rossi, M., 2014. Capital budgeting in Europe: confronting theory with practice. International Journal of Managerial and Financial Accounting, 6(4), pp.341-356.
Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.
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