Capital Budgeting - Essay Example

Topic: Capital Budgeting In recent past, capital budgeting has gained popularity as of the main functions ofmanagement. Capital budgeting refers the selections of the projects that will yield higher the returns of the company. There are various capital budgeting techniques which are used in evaluation of a project so to determine its viability they include; net present value, internal rate of return, profitability index, average rate of return, pay-back period and modified internal rate of return.

Guillermo Furniture is faced with three investment situations, which are to continue with the current production, adopt high-tech production, or act as a broker. Therefore, there is need to ascertain which of the investment will yield the highest returns to the firm. In order to carry out efficient investment appraisal, we will involve four capital budgeting techniques. The techniques that will be applied in this case will include; computation of net present value, internal rate of return, average rate of return and the profitability index.

Net present value is capital techniques which uses discounted cash flows. It estimate the present value of future cash out flow and discount the future cash flow using cost of capital of the country ( the cost of equity for unlevered firm and Weighted average cost of capital for the levered firm). After ascertaining the present value of all cash flow of Guillermo furniture, the cash flow are summed up (cash inflows are positive while cash outflows are negative) (Shapiro, 2005). The summation of the present value of cash flows results to the net present value.

The decision criterion under this technique is as follows; select the project if net present value is positive, reject the project if the net present value is negative, and consider other factors such government policy on adoption of the concerned project if the net present value is equal to zero. Under this method the higher the value the more profitable the venture is. Internal rate of return this popularly regarded as the discounting rate that equate the present value of expected cash outflow to the present value of expected cash inflow such that net present values equals to zero.

Internal rate of return is the minimum required rate of return from an investment; therefore it measures the efficiency of an investment. In investment appraisal for mutually exclusive project the higher the internal rate of return this reflect that the project is more profitable. The decision criterion under this method is; accept the project if IRR is greater than the company cost of capital, if the IRR is equal to the company cost of capital consider other factors and reject the project if IRR is lower than the company cost of capital (Shapiro, 2005).

Average rate return refers to the ratio of total cash inflow to the total amount or initial invested; it measures the profitability of an investment. Under this technique the higher the figure the better, as it showcases higher profitability. Usually, the management set the company ARR in order to evaluate the viability of the company. If the project ARR is greater than the predetermined ARR then the company should accept the project and reject if it is below the company ARR. In addition the company should consider factors if the project ARR is equal to that of the company.

The major limitation of this technique is that it fails to acknowledge the concept of time value of money (Shapiro, 2005). Profitability index, this technique is ratio of present value of all future cash inflows to the total amount invested in the project (initial investment), it quantity the amount of value produced per unit investment. In ranking mutually exclusive project the index the higher the profitability of the investment. The selection criterion under this technique is accept the project if the index is greater than one and reject if lower than one.

Net present value Net present value is the difference between the present value of expected cash inflow and present value of expected cash outflow, Present value of cash inflows, Assuming a free market interest rates of 10% and risk premium of 4.5% (inflation rate in the country) the cost capital of Guillermo Furniture will be 14.5% (Madura, 2009) and the life of the investment to be infinite( perpetuity), we will calculate the present values of cash inflow as follows, The cash inflows will be 1770208 for current therefore, PVCIF = annual annuity / cost of capital = 1770208/0.

145 =12208331 The present value cash flow will be Direct cost= 1499300/0.145 = 10340000 Over head = 174790/0.145 = 1205448(the amount of total amount of over head less depreciation) Tax expenses=19370/0.145=133586(assumption in this case is that the tax is constant over the life of the investment and that tax is paid in the current year thus ignoring differential discounting) Depreciation tax shield = 50000x0.42=21000XPVIFA27years, 14.5% = 21000x6.7184= 141086 (Assumption in this case is that the organization will not acquire any plant in equipment in the future and the buildings will not have any salvage value at the end of estimated economic life) Total PVCIF=12208331+141086= 12349417 Less total PVCOF=10340000+1205448+133586=11679034 NPV= PVCIF – PVCOF =670,383 High-tech option Cash inflows will be 2392266and the present value 2392266/0.

145=16498386 Add depreciation tax shield = 466667x0.42=196000and the present value 196000/0.145= 1351724 Total PVCIF in perpetuity at 14.5%= 17850110 Present value of cash outflows Purchase of equipment (initial investment) = (466667-50000) x10x1=4166670 Direct costs=1481560/0.145=10217655 Overhead costs=230864/0.145=1592166 Tax expenses= 89534/0.145=617476(assumption in this case is that the tax is constant over the life of the investment and that tax is paid in the current year thus ignoring differential discounting) Total PVCOF in perpetuity at 14.

5%=12427297 NPV = PVCIF – PVCOF =17850110-16593967=1256143 Broker Option Cash inflows are 2392266and the present value 2392266/0.145=16498386 Add depreciation tax shield = 466667x0.42=196000and the present value 196000/0.145= 1351724 Total PVCIF in perpetuity at 14.5%= 17850110 Present value of cash outflows Purchase of equipment (initial investment) = (466667-50000) x10x1=4166670 Direct cost= 1714240/0.145= 11822345 Over head cost=146318/0.145= 1009090 Tax expenses = 27317/0.145= 188393 Total PVCOF= 17186498 NPV = PVCIF – PVCOF =17850110-17186498 = 663612 Ranking the three investments according to the NPVs In order to arrive at the optimal decision under this method there needs to rank three project net present values 1.

High-tech option where NPV is 1,256,143. 2. Continuation with the Current production, NPV is 670,383 3. Brokerage option where NPV is 663,612 Recommendation The firm should switch from the current production plan to high tech production since this option has the highest net present value. This implies, adoption of high-tech production will increase the profitability of the company. Additional information required In the above analysis the computation of net present value the economic life of the investment was assumed to be infinite, if the firm had estimated the economic life of the investments.

In addition the cost capital for the company could have been provided would have helped in the investment appraisal process. Cost of capital is the level of minimum required rate of return from investment the company has made. Works Cited Madura, J. (2009). International Financial Management. Mason, Ohio : Cengage Learning. Shapiro, A. (2005). Capital budgeting and investment analysis. Upper Saddle River, New Jersey: Pearson/Prentice Hall.