Capital Budgeting of Sparklin Automotive Company - Assignment Example

? Capital Budgeting Introduction The future direction of any business enterprise solely lies on the decision taken by the management or owners. These decisions can have long-term or short-term impact on the business. However, the decision taken by the stakeholders must have relevant information. Decision making is regarded as successful depending on its ability to sort through all of the data and information to find the appropriate data to make the best decision. Good information must make a difference in a decision and it must also be future oriented (Dayananda, 2002). Strategic planning is important to the future success of a business enterprise. Capital budgeting is one of the ways that can help a company achieve its long term success through proper planning. Lack of good road map that a strategic plan provides, may lead to misallocation of company resources through addressing short-term issues. This would in turn compromise the long term needs of the company. Necessary Information Sparklin Automotive Company (SAC) has been a successful company within the automotive manufacturing industry, operating since the last eight decades. The company has come up with an innovative idea to launch a new spark plug which offers an enhanced mileage to vehicles i.e. up to 100,000 miles. In order to initiate the new spark plug production, the company needs to set up a new manufacturing plant which would need to be analyzed financially in order to consider it viable for SAC. The entire setup would require information pertaining to the cash inflows and the cash outflows that would occur as a result of carrying out the production of the new spark plugs. The financial information that would be needed should only include the relevant costs that would only be attributed as a result of carrying out the new spark plug production. Any past cost that has already be carried out prior to carrying out the new plan would have to be omitted from the calculations - such costs are considered to be sunk costs and that do not qualify to be considered within the calculations e.g. market research carried out prior to initiating the plan or any other cost which was incurred irrespective of the new project’s commencement. The following data would be used to evaluate the capital project: The new spark plug plant would need an initial investment of $1 billion in 2013, which would further be followed by another $500 million investment in 2014. The cash inflows that are expected as a result of this investment are: $300 million (2015), $350 million (2016), $385 million (2017), $400 million (2018), $450 million (2019), and $500 million (2020). All of these expected inflows are considered to be after-tax inflows. It is also expected that the new plant would not attract any Capital Gains; hence no tax savings would be gained. SAC’s current cost of capital is 10%. Capital budgeting The firm’s senior financial officers are faced with two important tasks in a firm. One of the tasks is to make decisions for improving the company’s return on equity. The other task is to find adequate funds for investment opportunities that may arise (Dayananda, 2002). Capital budgeting is the process in which a business management determines whether projects such as long-term investment or building a new plant are worth undertaking. Basically, business should pursue all opportunities and projects that will increase shareholder’s value. However, because of limited nature of capital available for new projects, management needs to implement capital budgeting techniques to determine which will result to high return on a given period of time. Weighted Average Cost of Capital (WACC) Weighted Average Cost of Capital is the calculation of a firm’s cost of capital that involves proportionate weighting of each and every category of capital. When calculating the firm’s weighted average cost of capital, all capital stock such as preferred stock, common stock, bonds, and any other long-term debt are all included. The formula for WACC is given below: Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate (Dayananda, 2002) Decision makers in a firm use models such as the APT or the CAPM to estimate a discount rate necessary for each individual project, and use the WACC to reflect the selected financial mix. In common circumstances, choosing a discount rate are to apply a Weighted Average Cost of Capital that applies to the entire firm. A higher discount rate may be more important if only if a project’s risk is higher than the entire firm’s risk (Dayananda, 2002). Capital Budgeting Techniques There are various Capital budgeting techniques that can be used to assess SAC’s financial viability of carrying out its new plan. The most notable techniques that are used to appraise a project include: Net Present Value (NPV) Net Present Value is a capital budgeting technique that is used to assess the financial feasibility of any new project. The method used to calculate the NPV of an investment project is to calculate the present value of all the cash inflows less the cash outflows associated with the project. The present value of the cash inflows and outflows are discounted at a suitable cost of capital. Discounting is a process through which future cash flows are discounted back to the present. NPV is the present value of cash flows (calculated at the present time period) less initial investment made to fund and initiate a project. To decide the fate of any given project via the NPV technique, a common rule is used i.e. if the NPV of a given investment project is positive it should accepted. The notion behind this decision rule is that positive value carried calculated via the NPV calculation would add value to the firm and hence the shareholder’s wealth thus this would perfectly align with the overriding purpose of an organization of creating value for their shareholders. Any negative NPV is rejected immediately as it is considered to decrease shareholder wealth (Dayananda, 2002). Considering the above mentioned situation, the NPV for SAC with respect to the new spark plug project would be as follows (all amounts are in ‘000,000): 2013 2014 2015 2016 2017 2018 2019 2020 Investment (1,000) (500) Cash Inflows 300 350 385 400 450 500 Cash Flows (1,000) (500) 300 350 385 400 450 500 Discount Factor @10% 1 0.909 0.826 0.751 0.683 0.621 0.564 0.513 PV @ 10% (1,000) (454.5) 247.8 262.9 263 248.4 253.8 256.5 DF @ 12% 1 0.893 0.797 0.712 0.636 0.567 0.507 0.452 PV @ 12% (1,000) (446.5) 239.1 249.2 244.9 226.8 228.2 226 NPV = PV of Inflows less outflows NPV = 77.9 = 77,900,000 The positive NPV suggests that the project would add value to the shareholders wealth since it is a positive result. A positive NPV is a good sign and hence the project should be undertaken (had the project resulted in a negative NPV, it should not have been accepted). Internal Rate of Return (IRR) Internal Rate of Return (IRR) is the rate of return at which a project’s NPV is considered to produce a “zero” NPV. This suggests that the IRR displays a rate at which the investment in question is at a break-even point i.e. the PV of the inflows and the outflows are all equal. The IRR gives a rate of return with respect to any investment under analysis. A project should be accepted if an investment’s IRR is greater than the company’s (shareholders) required rate of return. IRR is a complex capital budgeting technique and does not provide accurate results. It is carried out on a trial and error method. To calculate the IRR, NPV at a higher discount rate should be calculated to ascertain a negative NPV. Following the determination of a negative NPV, the IRR would be calculated which would five a rate at which the NPV would be zero (Dayananda, 2002). Using the above mentioned data, IRR would be calculated as follows: IRR = LDR + [PV1/PV1-PV2]* (HDR-LDR) LDR = Lower Discount Rate HDR = Higher Discount Rate PV1 = Present Value at Lower Rate of Return PV2= Present Value at Higher Rate of Return NPV of the above mentioned data at a discount rate of 12% would result in a negative figure = (32,000,000) IRR = 10% + [77,900,000/77,900,000+32,000,000]* (12%-10%) IRR= 11.4% Hence in terms of IRR (11.4% < 12%), the project is not viable and should not be accepted. Profitability Index Profitability Index (PI) is also a capital budgeting technique that is used to analyze the financial viability of a project. PI measures the proportion of payoff to the investment of a project. This technique is used in circumstances where there is more than one project under consideration. The PI measure is a good indicator which helps in ranking different projects (all of them giving positive NPVs). Based upon these rankings, a project is considered. PI technique is also used while assessing a single project as well. The decision rule is such that if the PI is greater than 1, a project should be accepted and if it is less than 1, the project should be rejected. PT is calculated as follows: PI = PV of future Cash Flows ? Initial investment PI (10%) = 1532.4/1454.5 = 1.05 Decision: The project should be undertaken since its PI is greater than 1. Payback Period Payback Period is a capital budgeting technique which evaluates the time period which would needed to recover the investment (Dayananda, 2002). Payback period measures the feasibility of projects in terms of the number of years that it takes to pay back an initial investment. The shorter the payment period, the sooner the firm recovers its initial investment. Whether a payback period is poor or good depends on the firm’s criteria for evaluating projects. Payback Period (SAC) = -1000 – 500 (Yr 1) + 300 (Yr 2) + 350 (Yr 3) +385 (Yr 4) + 400 (Yr 5) Payback Period (SAC) = 65/ 450 * 12 = 1.7 approximately 2 months Payback Period = 5 Years 2 months Considering the fact that SAC expects the equipment to have a useful life of 5 years, then the project is not viable in terms of payback period. Affect of Sales Volume Changes on Net Operating Income Price and cost increases have both benefits as well as setbacks for an organization. If the volume of sales increases for a company, it is always considered to a positive sign for the company it would bring in additional revenue and hence enhanced net operating income for the company. A price increase has both positive and negative results. A price increase may bring in additional revenue but might also affect the net income as customer might opt for substitute products resulting in negative effects for the company e.g. reduced revenue/net operating income. However, the realization of positive results from price increase will depend on how strong the price increase mobilizes sales as opposed to reduction in customers (Dayananda, 2002). Changes in sales volume will ultimately affect net operating income. An increase in sales volume will add to the operating income hence more profit. Expenses have negative effect in the firm’s profit. Increasing costs will reduce the firm’s profit because it will reduce the net income. Therefore, to ensure a more positive net operating income, a firm has to ensure that it reduces its operating costs. Effect of Sales Volume Increase on Costs Profits depend on increase in sales volume and how well the costs are managed. Costs include both fixed and variable costs. Variable costs involve direct raw materials and labor costs hence variable costs depend on sales volume. An increase in sales volume will result to increase in variable costs. Businesses incur fixed costs even without sales. At certain levels of sales and production, fixed costs are always constant. However, outside these levels fixed cost may vary with sales volumes. Unit fixed cost are inversely proportional to sales volume. This means that unit fixed costs increase when sales volume falls. This is because the fixed costs are spread over fewer units. On the other hand, unit fixed costs fall when sales volume rise. The reason behind this decline is the ability of the costs to be spread over more units. The unit variable cots will remain constant irrespective of sales volume. Conclusion and recommendations Capital budgeting is a step-wise process that firms use to determine the merits of an investments project (Dayananda, 2002). The ultimate decision to reject or accept an investment proposal depends on the project’s rate of return. Capital budgeting is important because it creates measurability and accountability. SAC is a profit oriented business. The capital budgeting process will help SAC to determine its long-term financial and economic profitability of its investment project. On it’s quest to purchase new manufacturing specialty spark plugs; SAC must use capital budgeting techniques such as IRR, pay back period, PI, NPV to analyze the return on the equipment. After the analyzing the new spark plug for SAC, there are conflicting results on whether the project should be undertaken or not. The IRR and payback period results show that the project is not viable enough to be undertaken. However, the PI and NPV results show a positive result suggesting a viable result. Therefore, the decision whether to undertake the project or not does not lie entirely on capital budgeting techniques but other factors has to be included in the decisions. Recommendations: All the management head to be included in decision making More research should be done regarding the benefits and disadvantages of buying the new equipment. Other capital budgeting techniques should be used in addition to IRR, NPV, PI, payback period. References Dayananda, D. (2002). Capital budgeting: Financial appraisal of investment projects. Cambridge [u.a.: Cambridge Univ. Press. Read More