Capital Budgeting Analysis For Solus (An Australian Manufacturer)

NPV

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13.8%

Year

0

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1

2

3

4

5

 Cash Flows

–         4,800,000

    2,080,000

   1,200,000

   1,930,000

   1,105,000

   1,245,000

 Discount Factor

              1.00000

        0.87873

       0.77217

       0.67854

       0.59625

       0.52395

 Present Value

–         4,800,000

    1,827,768

       926,609

   1,309,575

       658,860

       652,316

 NPV

$575,129

NPV

$575,129

Rate

13.8%

Year

0

1

2

3

4

5

 Cash Flows

–     4,800,000

    2,080,000

   1,200,000

   1,930,000

   1,105,000

             1,245,000

 Discount Factor

           1.00000

        0.87873

       0.77217

       0.67854

       0.59625

                 0.52395

 Present Value

–     4,800,000

    1,827,768

       926,609

   1,309,575

       658,860

                 652,316

 NPV

$575,129

Year

0

1

2

3

4

5

 Cash Flows

–     4,800,000

    2,080,000

   1,200,000

   1,930,000

   1,105,000

             1,245,000

NPV

$575,129

Using NPV function the correct way

Using IRR Function

IRR

19.14%

Payback (normal)

Year

0

1

2

3

4

5

Cash Flows

–     4,800,000

       2,080,000

      1,200,000

      1,930,000

    1,105,000

      1,245,000

Cumulative Owing

–     4,800,000

–     2,720,000

–    1,520,000

         410,000

    1,515,000

      2,760,000

PB

                      2.79

Cost of Asset

 $     4,800,000

Converting Cash Flows to Accounting Profit

Year

1

2

3

4

5

Revenue

         2,080,000

     1,200,000

      1,930,000

      1,105,000

    1,245,000

Salvage Value

–      325,000

Depreciation

–           895,000

–       895,000

–        895,000

–        895,000

–      895,000

Profit

         1,185,000

         305,000

       1,035,000

          210,000

           25,000

Profit

         1,185,000

         305,000

      1,035,000

          210,000

          25,000

Ave Profit

            552,000

ARRG

11.50%

Profitability Index (PI)

Rate

13.8%

Year

0

1

2

3

4

5

 Cash Flows

– 4,800,000

   2,080,000

   1,200,000

   1,930,000

   1,105,000

   1,245,000

 Discount Factor

       1.00000

      0.87873

      0.77217

      0.67854

      0.59625

      0.52395

 Present Value

– 4,800,000

   1,827,768

      926,609

   1,309,575

      658,860

      652,316

 NPV

$575,129

 PI

1.12

NPV

Net present value of the project is $575129 which means that this project is acceptable because it has positive net present value (NPV). Positive net present value denotes that if solus (an Australian manufacturer) invest the capital on this project then he will be benefited by $575129. Net present value is positive, so it can be concluded that solus (an Australian manufacturer) should invest in this project to earn profit of $575129 (considering time value of money).

IRR

Internal rate of return is a rate of return where present value of cash inflows is equal to present value of cash outflows. At 19.14%, present value of cash outflow will be equal to present value of cash inflow.

Payback Period

Payback period is a period which defines the length of time required by a company to recover the initial cash outflow. In this case payback period is 2.79 years, which means that Solus (An Australian manufacturer) will recover his initial outlay cost in 2.79 years, at 2.79 years he will recover all his investment in the project. In case this life of project is 5 years, and Solus is able to recover all this initial outlay in 2.79 years, hence this project should be accepted by him.

ARR

Accounting rate of return is a rate of return which is also known as average rate of return. It is used as accounting tool in capital budgeting. In present case study accounting rate of return is 11.50%, which means that Solus will generate net income (which will be 11.50% of average investment). Accounting rate of return is positive; hence Solus should accept the project. Accounting rate of return can be calculates as: Average profit/Average investment.

PI

Profitability index can be calculated as =present value cash inflow/present value of cash outflow. When profitability index(PI) is 1, then there will be no profit no loss(break-even).In present case profitability index (PI) is 1.12 which is more than 1, it means that present value of cash inflow is 1.12 times of present value of cash outflow. It is favorable; hence Solus should accept the project.

Conclusion:

Srl. No.

Technique

Decision

1

NPV

 $      575129

Accept the project

2

IRR

19.14%

Accept the project

3

Payback Period

                2.79

Accept the project

4

ARR

11.50%

Accept the project

5

PI

              1.12

Accept the project

After considering all the techniques, we can conclude that project is viable; Solus (An Australian manufacturer should accept the project).

Treatment of Salvage Value

In this question, Salvage value is considered in the cash inflows at the end of the 5th year for all the techniques except ARR. In ARR, salvage value is not a part of profit; hence the same is removed while computing the Average Profits.

Treatment of Loan Repayments

In this question, Interest Payment along with the Principal considered in the cash outflows at the end of the each year. Equal annual installment was computed using PMT formula which comes to $ 610631.

Debt Rate

8.6%

Borrow

2400000

(b)

OB

Interest

Repayment

CB

$2,400,000

$206,400

$2,606,400

$610,631

$1,995,769

$1,995,769

$171,636

$2,167,405

$610,631

$1,556,774

$1,556,774

$133,883

$1,690,656

$610,631

$1,080,025

$1,080,025

$92,882

$1,172,907

$610,631

$562,276

$562,276

$48,356

$610,631

$610,631

$0

(a)

Repayments

$610,631

NPV

Inputs taken from the question

Cost of new machine

 $  12,800,000

Cost of Capital after tax

10.65%

Estimated life of machine

                  4

Salvage Value at the end of year four

 $      960,000

Diminishing Value Depreciation Rate

50.00%

Gain on Sale of machine

 $      160,000

Book Value at the end year four

 $      800,000

Working capital Invested in year zero

 $      370,000

Working capital Recovered at the end of year four

 $      370,000

Taxation rate

27%

Annual Marketing and Administration expense

 $      251,000

Annual Sales for year one

 $  24,016,000

Annual sales growth

4%

Projected Inflation

2%

Annual Operating Expenditure 68% of sales

68%

Investment Allowance

20%

Computation of taxable income:

Particulars

0

Revenue

Operating Expenditure

Gain or Loss on Sale

Investment Allowance

Depreciation

Marketing and Administration

Total taxable income

Tax @ 27%

Computation of Cash inflows and Cash outflows:

Particulars

0

Revenue

Operating Expenditure

Salvage Value

Marketing and Administration

Initial Outlay

(12,800,000)

Working Capital

(370,000)

Tax

Net Cash flows

(13,170,000)

PVF @ 10.65%

1.00000

Present Value of Cash Flows

(13,170,000)

NPV

 $  8,979,300

Recommendation: Company should invest in the project as Net present value is positive which means that present value of cash inflows exceeds by $ 8979300 from present value of cash outflows. Positive net present value means that we can accept the order.

Notes (Workings): –

Annual sales

Price per unit

$158

Units sold per annum

         152,000

Total Revenue

$24,016,000

Cash Operating Expense @ 68%

$16,330,880

Feasibility Study – Ignored as the same is sunk cost and same are ignored in decision making analysis.

$500,000

Head Office Expense – Ignored as no additional cost incurred due to this project. Only incremental costs considered for decision making analysis.

$230,000

Depreciation Schedule

Cost of Asset

 $  12,800,000

Depreciation Rate

50.00%

Depn. Amount Yr 1

 $   6,400,000

Written Down Value (WDV)

 $   6,400,000

Depreciation Rate

50.00%

Depn. Amount Yr 2

 $   3,200,000

Written Down Value (WDV)

 $   3,200,000

Depreciation Rate

50.00%

Depn. Amount Yr 3

 $   1,600,000

Written Down Value (WDV)

 $   1,600,000

Depreciation Rate

50.00%

Depn. Amount Yr 4

 $      800,000

Written Down Value (WDV)

 $      800,000

Salvage Value

 $      960,000

Gain on Sale

 $      160,000

Capital Gain(CG) – If salvage value (SV) is higher than the book value(BV)

Book Value(BV) – Cost of Asset less accumulated depreciation

(i)

Sensitivity Analysis to Sales Revenue

Particulars

1

2

3

4

Sales Revenue

 $  24,016,000

 $ 24,976,640

 $ 25,975,706

 $ 27,014,734

PVF @ 10.65%

0.90375

0.81677

0.73815

0.66711

Present Value of Sales Revenue

 $  21,704,474

 $ 20,400,047

 $ 19,174,017

 $ 18,021,669

Cumulative Present Value of Sales Revenue

 $  21,704,474

 $ 42,104,521

 $ 61,278,538

 $ 79,300,207

Hence Sensitivity (%)

(Present value of Sales Revenue – Present value of sales revenue at which NPV will be zero)

(Present value of Sales Revenue

11.32%

(ii)

Sensitivity Analysis to Cost of Capital

Hence Sensitivity (%)

Change * 100

Base

22.54%

Scenario analysis & sensitivity analysis play a very important role to know the profitability of the project. But scenario analysis provides additional insight which is not provided by sensitivity analysis. Scenario analysis assesses different type of instabilities & the desired routes where it can be performed. Scenario analyses can be defined as a process to assess the future outcome whereas sensitivity is the uncertainty in outcome in terms of mathematics. It is used to examine how independent variable impacts the dependent variable. Scenario analysis considers the uncertainty in all aspect which is not considered by sensitivity analysis.

Risk has been priced in this project is due to inflation, sales and marketing expenses will increase due to inflation. But management of Multimaxx steel division is confident that return on investment is in accordance with risk because additional annual sales will overcome the effect of increases in costs due to inflation.

References:

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K.L. Maheshwari (2001), Managerial Economics, India: Sultan Chand & Sons, 885-997.

Anonymous (2005), International Good Practice: Guidance on Project Appraisal Using Discounted Cash Flow, India.

Joseph Tham (2008), Prospective Analysis: Guidelines for Forecasting Financial Statements, London.

Ignacio Velez-Pareja( 2008),To Plug or Not to Plug, that is the Question: No Plugs, No Circularity: A Better Way to Forecast Financial Statements, PI hall, United kingdom.

Ignacio Velez-Pareja (2008),A Step by Step Guide to Construct a Financial Model Without Plugs and Without Circularity for Valuation Purposes, PI hall, United kingdom

Sergei Cheremushkin (2008), Long-Term Financial Statements Forecasting: Reinvesting Retained Earnings, London.

Shveta Singh(2002), Introduction to capital budgeting, Department of Management Studies, Indian Institute of Technology, India

P.K. Jain (2005),Net present value calculation, Department of Management Studies, Indian Institute of Technology Delhi, India

Surendra S. Yadav (2009), Techniques in capital budgeting, Department of Management Studies, India.