Capital Budgeting Analysis
The company Booli Ltd started its business about 50 years ago when it started its business with repairing of electronic items. With time the company expended its business and started to manufacture various electronic items. The company manufactures an item which can be improved due to technology advancement. The company has been doing market survey and research in order to evaluate the validity of this new product. Before executing the production of this new project it is important that we first analyse the financial benefits of the proposed plan.
To evaluate the financial viability; we have conducted the capital budgeting analysis of the data collected using marketing study. (Adelaja, 2015) The following report contains data on the financial analysis of the said proposal.
The following are the few tools of capital budgeting which will helps us evaluate the financial viability of the said proposal. (Atkinson, 2012)
Pay- back period refers to the time period within which the investor can expect to earn back the amount which has been invested for the execution of the new project. There are two types of pay- back period, discounted and non-discounted. The type which uses the normal cash flows without discounting is the non-discounted pay- back period. (Berry, 2009)
For the given proposal the pay- back period results to be 2 years approximately (2.02) this means that the company will have three more years to earn profits. All the revenues earned in these three years will contribute toward the profit of the company.
Profitability index is ratio between the cash inflows and cash outflows. The cash inflows is the sum total of discounted cash inflows. The ratio helps the investor calculate the inflow per unit of outflow. When the ratio is more than one, then the project is profitable. (Bierman & Smidt, 2010)
For the given proposal the profitability index is 1.71 times. The cash inflow for every dollar is $1.71. This indicates that the company will earn $0.71 for each dollar invested initially in the project.
Internal rate of return is the tool of capital budgeting that calculates the real or actual return that is expected by the project to earn. This internal rate is totally based on the cash inflows and outflows. Change in any figure of cash will affect the internal rate of return. (Datar, 2015)
The internal rate of return for the given project of the company is 37%. This indicates that the project is expected to earn a return of 37% on the initial investment. The company expects to earn about 12%, whereas the project will earn 37%.
Payback Period
The most commonly used tool of capital budgeting is net [resent value. This is the net total of cash inflows and cash outflows. When the net present value is more than zero, then the project is expected to generate profits. (Dayananda, Irons, Harrison, Herbohn, & Rowland, 2008)
For the given project we see that the net present value sums up to $ 40,214,608 approximately. Therefore, the project is expected to earn high cash inflows.
Sensitivity analysis id the capital budgeting tool, that quantifies the effect of change in input variable on the output. This helps in uncertainty analysis. The sensitivity of the proposal with respect to change in the sales price and sale quantity has been calculated in our discussion below. (Kuti, 2014)
In discussion below we have calculated the effect of change in sales price of the product on the net present value of the project. By increasing the sales price of the product by 1%we see that the net present value increases by 4.35%. Taking the initial figures the net present value amounted to dollar 40.2 million, but with increase in the sales price the net present value increased to dollar 41.9 million.
We have also calculated the effect of change in sales price on the internal rate of return, non discounted payback period and the profitability index.
- 1% increases in price changes the IRR from 37 to 38%.
- 1% increase in price changes non discounted payback period from 2.02 years to 1.99 years
- 1% increases in price changes the profitability index from 1.71 to 1.74 times.
In discussion below we have calculated the effect of change in sales quantity of the product on the net present value of the project. By increasing the sales quantity of the product by 1% we see that the net present value increases by 2.23%. Taking the initial figures the net present value amounted to dollar 40.2 million, but with increase in the sales quantity the net present value increased to dollar 41.1 million.
We have also calculated the effect of change in sales quantity on the internal rate of return, non discounted payback period and the profitability index.
- 1% increases in quantity changes the IRR from 37% to 37.48%.
- 1% increase in quantity changes non discounted payback period from 2.02 years to 2 years
- 1% increases in quantity changes the profitability index from 1.71 to 1.73 times.
Therefore, from the above calculations we can see that net present value is most sensitive to changes into input. Any minor change in the input of the project might affect the net present value with high degree.
Capital budgeting tool is a detailed analysis of the cash inflows and cash outflows. Information on these cash flows is connected based on market research and detailed study. There are a lot of assumptions made when these cash flows are calculated. (Menifield, 2014)This means that the expected cash flows will be at earned only when these assumptions hold true. If there are changes in any of the assumptions the cash flows might turn out to be different. This will result in a new conclusion. Therefore we can say that there will always be a factor of uncertainty in the capital budgeting decisions. This uncertainty cannot be recorded but it might be taken into control by making proper and valid assumptions. (Noreen, 2015) The required rate of return which is used in the capital budgeting is not so easy to calculate. This rate is based on the cost of the firm and might change in the future. There will also be a risk involved in this rate of return. Therefore an investor should not totally rely on the capital budgeting decisions in order to evaluate the investment proposal. All the quantitative and qualitative information must be considered before accepting or rejecting a new proposal. (Peterson & Fabozzi, 2012)
Profitability Index
Hence we can say that there will be a forecasting risk involved in the capital budgeting decisions but it can be overcome if the project is managed efficiently. Still the manager of the project should keep a margin for the risk of uncertainty while evaluating the project.
The capital budgeting analysis is a detailed analysis of the financial data. The process of capital budgeting is not so complex to carry out, but the process of collection of data for this is complicated. (Rivenbark, Vogt, & Marlowe, 2009)While evaluating a new proposal with the help of capital budgeting analysis, there are various inclusions and exclusions. There are relevant and irrelevant cots which are important to be classified and included in taking the final decision. When a company executes a new project, it does so with the view to earn profits. If the company looses profit due to this new project, then such looses play an important role in the decision making. (Seal, 2012) When a company loses one benefit when it opts for another, then such losses of profit are refer to as opportunity costs. These costs are relevant cost and are to be included in decision making.
In the given case Booli limited might lose sale of other products if it accepts the proposal of production of new product. Loss of revenue from existing products due to new product is a kind of opportunity cost. This cost should be considered as cash outflows in making the capital budgeting decisions. The company should include these costs while evaluating the financial viability of this new proposal.
Conclusion
There are a lot of factors which are to be taken while evaluating the validity of a new project. It is important that the figures used are based on though study and investigation. The whole analysis is based on detailed study and a lot of assumptions, which creates an uncertainty risk. The degree of this risk is based on the actual conditions that turn out during the execution of the proposal. The analysis done above gives us an overall view on the financial outcome. The results depict that the new proposal will generate values for the company. The project is expected to be profitable.
Hence based on all the details above, the project seems acceptable
References
Adelaja, T. (2015). Capital Budgeting: Investment Appraisal Techniques Under Certainty. Chicago: CreateSpace Independent Publishing Platform .
Atkinson, A. A. (2012). Management accounting. Upper Saddle River, N.J.: Paerson.
Berry, L. E. (2009). Management accounting demystified. New York: McGraw-Hill.
Bierman, H., & Smidt, S. (2010). The Capital Budgeting Decision. Boston: Routledge.
Datar, M. S. (2015). Cost accounting. Boston: Pearson.
Dayananda, D., Irons, R., Harrison, S., Herbohn, J., & Rowland, P. (2008). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press.
Kuti, M. (2014). Crowdfunding: How to Fund Your Business Idea. Retrieved from www.business.gov.au: https://www.business.gov.au/info/run/finance-and-accounting/finance/crowdfunding-how-to-fund-your-business-idea
Menifield, C. E. (2014). The Basics of Public Budgeting and Financial Management: A Handbook for Academics and Practitioners. Lanham, Md.: University Press of America.
Noreen, E. (2015). The theory of constraints and its implications for management accounting. Great Barrington, MA: North River Press.
Peterson, P. P., & Fabozzi, F. J. (2012). Capital Budgeting. New York, NY: Wiley.
Rivenbark, W. C., Vogt, J., & Marlowe, J. (2009). Capital Budgeting and Finance: A Guide for Local Governments. Washington, D.C.: ICMA Press.
Seal, W. (2012). Management accounting. Maidenhead: McGraw-Hill Higher Education.
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