Capital Budgeting

Capital Budgeting

Name

Institutional Affiliation

Capital Budgeting

Introduction

Many methods are used to value assets and projects in a company. The selection of the technique used is at the discretion of the management team. There is the need to evaluate both the cash inflows and outflows. The former refers to revenues streams that add income and brings in money from the project. However, the cash outflows refer to payments and expenses made by a business in any fiscal year. One has to consider both the price and quantity in the sales revenues. However, there are multiple items found under the costs and expenses. Expenses considered are both the fixed and variable costs. Other expenses considered are depreciation. This cost takes into account the cost of the asset, the salvage value and the useful life of an asset. It is vital to consider both the net cash flows in the business. One should consider whether to use discounted or undiscounted cash flows. Methods such as the payback period and accounting rate of return use the non-discounted cash flows. Such methods are easy and straightforward to compute. However, the Net Present Value (NPV) and the Internal Rate of Return (IRR) takes into account the discounted cash flows. Application of the capital budgeting evaluates the viability of any project.

Sales
Variable costs
Fixed costs per year
Depreciation

Sales
Variable costs
Fixed costs per year
Depreciation

Question 1

Auditizz Electronics has a non-discounted payback period of 3.51 years. This value indicates that the business will recover its initial capital outlay within less than four years (San Ong & Thum, 2013). One should select projects with shorter payback periods.

Year Cash flows Cumulative cash flows    
0 -125812500      
1 21957500 -103855000    
2 35576840 -68278160    
3 45751375.7 -22526784.3    
4 44166239.18 21639454.88 0.51  
5 39172500      
         
Payback period   3.51    

Question 2

Accounting rate of return is computed as the quotient of average net income and average book value. Auditizz Electronics had an average net profit of 12162390 and an average book value of 103500000. This computation results in an ARR of 11.75%. One should accept the project as the ARR exceeds the required rate of return.

Accounting rate of return  
Average net income 12162390.98
Average book value 103500000
ARR 11.75%

Question 3

The business has an NPV of 8637646. One should accept the project as it has a positive NPV (San Ong & Thum, 2013). On the other hand, it has an IRR of 13%. It is vital to allow the project as its IRR exceeds the internal rate of return. A manager is likely to get a profit by investing in the business.

NPV 8,637,646
IRR 13%

Question 4

Sensitivity analysis takes into account the aspect of risk in any project. The managers have to take into account the various changes in the business environment (Arnold & Yildiz, 2015). There is the need to evaluate the NPV at any particular point in time. One has to come up with estimates of the price and the quantity they expect to sell in a fiscal year. There is the need to evaluate both the revenues and expenses.

The management team has to come up with both the base price and quantity. The project takes four years and will have the following 850, 875.5, 902 and 929 respectively. However, the best case analysis estimates that there will be a 20% increase in the base year price. It is estimated that the price increases to 1020 and 1082 respectively. However, the worst case scenario indicates a 20 per cent decrease from the price in the base year. It is expected that the business will sell its products at 680 and 721.41 respectively. The changes in prices will affect the Net Present Value posted by the company in any financial year.

Furthermore, it is vital to evaluate the changes in the output from one financial year to the other. The units sold would increase by 20%. As a result, the units will increase to 126000 in the best case scenario and 84000 in the worst case scenario. This computation results in an NPV of 19029545 in the most likely scenario, 33761157 in the best case scenario and 1998497 in the worst case scenario. It is evident that each of the scenarios has positive NPV.

Consequently, the project is likely to increase the profitability of the business in any fiscal year. An evaluation of the net income provides different answers. It is evident that the most likely scenario has a net profit of 7099166.67, 27017667 in the best case scenario and -11173333.33 in the worst case scenario. The last case indicates that the project may make a loss of -1117333. Such a performance may affect the overall profits posted by a business.

  Base Units Units
Units 105000 126000 84000
Price 850 1020 680
Variable costs 515 515 515
Fixed costs per year 11200000 11200000 11200000
  Base Units Units
Units 105000 126000 84000
Price 850 1020 680
Variable costs 515 515 515
Fixed costs per year 11200000 11200000 11200000
       
Sales 89250000 128520000 57120000
Variable costs 54075000 64890000 43260000
Fixed costs per year 11200000 11200000 11200000
Depreciation 13833333.33 13833333.33 13833333.33
EBIT 10141666.67 38596666.67 -11173333.33
Taxes 3042500 11579000 0
Net income 7099166.667 27017666.67 -11173333.33
Depreciation 13833333.33 13833333.33 13833333.33
Total CF 20932500 40851000 2660000
NPV 19029545.45 33761157.02 1998497.37

A change in prices shows that the NPV moves in a downward trend. The best-case scenario had the highest value, while the worst case scenario has the lowest NPV value.

Capital Budgeting

It is evident that the changes in the most likely, best case and the worst case scenario have to be shown in the graphs. It is evident that both the units and price have increased consistently from one scenario to the other. This performance indicates that the business has to consider both the right and the left sides of the base units and base price.

Capital Budgeting

Capital Budgeting

Forecasting risk

It is evident that the worst-case scenarios may negatively impact the profits posted by a business. This event presents a risk that the management should take care of at all times. One may consider accepting, avoiding or insuring against the threats (Haimes, 2015). The managers have to pay keen attention to the forecasting risk. It is evident that the worst-case scenario has risks that the business should carefully consider and evaluate. There is the need to assess the likelihood of the risk occurring. Failure to put in place correction measures might lead to the company incurring losses.

Question 5

Recommendation

Managers should undertake the project entirely. It is evident that the project has a positive NPV and also has a shorter payback period. Undertaking the project is likely to increase the profitability of the firm both in the short and long term.

Question 6

Efficient market hypothesis considers that the investors and the market players know the news in the market. These issues affecting the value of any project (Degutis & Novickytė, 2014). It estimates that the investors would react positively to news that the project would have a positive NPV. Such an NPV would increase the profitability of the business hence its value in the long run. The high return is in line with the wealth maximization of the shareholders’ funds. As a result, the market price per share is likely to increase; hence, the investors can capitalize on the appreciation of prices.

Question 7

A positive NPV implies that the project would generate profits. These returns will result in the appreciation of the share price. There will be excess demand for the company shares hence increasing stock prices.

Conclusion

Capital budgeting is a vital step in the appraisal of projects. The massive outlay of cash makes such projects risky. It is essential for the management to use the discounted cash flow method in the assessment of the projects. Such methods take into account the effects of inflation and the time value of money. The net present worth and the internal rate of return should be used as the basis for accepting or rejecting a project. It is evident that the project has a positive and a short payback period. Besides, the implementation of such a project is likely to benefit the company and increase the shareholders’ wealth. One should also evaluate the effect of risk on the project. Such a move is facilitated by the sensitivity analysis conducted in the evaluation stage. It is vital to consider the most likely, the best case and the worst-case scenario. This computation may also involve evaluating the NPV for each of the cases. One may also assess the scenario based on both the changes in prices and quantities. There is also the need to evaluate the effect of changes on NPVs of each project. Assessment of risk enables the management to determine the right way to respond to the risk. These moves prevent a business from incurring huge losses.

References

Arnold, U., & Yildiz, Ö. (2015). Economic risk analysis of decentralized renewable energy infrastructures–A Monte Carlo Simulation approach. Renewable Energy, 77, 227-239.

Degutis, A., & Novickytė, L. (2014). The efficient market hypothesis: a critical review of literature and methodology. Ekonomika, 93(2), 7-23.

Haimes, Y. Y. (2015). Risk modeling, assessment, and management. John Wiley & Sons.

San Ong, T., & Thum, C. H. (2013). Net present value and payback period for building integrated photovoltaic projects in Malaysia. International Journal of Academic Research in Business and Social Sciences, 3(2), 153.