The Project Appraisal and Capital Budgeting Techniques - Essay Example

?REPORT TO MANAGER The cash inflow of the project shows positive stream throughout the project but the project cannot be accepted or rejected withoutlooking only at the cash inflows. Therefore to find out whether the project is feasible for the company or not, various capital budgeting techniques have been used. The analysis of these techniques would help in determining whether project should be accepted or rejected. Payback Period The initial investment of the company is calculated as $158,640,700. Payback period is the time in which the initial investment of the project will be recovered (Peterson, and Fabozzi, 2002)The company is able to recover its initial investment in 2.8 years and the rest of the stream after 2.8 years is Net cash inflow of the project. However using discounted payback period, the company would be able to recover its initial outflow of the project in 3.47 years. The discounted payback period gives more accurate picture of the project feasibility because it takes present value of the future cash inflows (Trahan, and Gitman, 1995). Considering the investment required, the project should be accepted using the payback period technique. Net Present Value The Net present value of the project is $71,467,984. The value shows the difference between the initial outflow and present value of future cash inflow (Shapiro, 1978). Therefore, the management should undertake the project as the NPV is positive and very high so the project would increase the profitability of the company. Internal Rate of Return Internal Rate of Return of the project is calculated as 25%. This is the rate at which the net present value of all future inflows would be equal to the initial outflow of the project. It means the project is beneficial for the company because IRR is greater than the cost of capital which is 10% and therefore the project should be accepted. Profitability Index The profitability Index of the project is 1.4505 which shows the ratio of present value of future cash inflows and initial outflow of the project. The value is greater than 1 which shows that the company would be profitable if it undertakes the project. Moreover, the value also shows that the company would earn approximately 45% more of the total cost of the project. Therefore, the project should be accepted. Modified Internal Rate of Return The MIRR gives more accurate and realistic picture of the cost and profitability of the project because this technique assumes that the positive cash flows will be reinvested at cost of capital i.e. 10% in this case. The MIRR of the project is 18% which is also greater than the cost of capital. Thus, the project should be accepted. Recommendation The company should accept the project because all the project appraisal and capital budgeting techniques used to evaluate the feasibility of the project are showing positive results and therefore the project should be accepted. If company undertakes the project, it would be able to recover its initial investment in 3.47 years (inflation adjusted) which is beneficial for the company. After 3.47 years the project will give additional future cash inflows till the end of the project. NPV of the project is also favorable and is showing the healthy earning for the company. IRR and MIRR of the project are greater than the cost of the capital and indicating positive sign for the company to undertake the project. Profitability index of the Project is greater than 1 hence also supporting the project. Thus, the project should be accepted. MODEL DESIGN REPORT The model is prepared in Excel and it has been divided into three sections which are input, calculation, and output. All the information has been included in the input section by the user. Using input, calculation has been done through formulas and commands. The calculated result is then produced in the form of output. INPUT The model allows the user to enter the information as input in the excel sheet. The input section has been divided into seven areas. The production part comprises of price of product, units of production, and variables price and units. The user can also enter the advertisement cost as input in the excel sheet. The advertisement part includes the basic advertisement cost in the first year, its growth rate, and other advertisement expense (per unit). In employment part, the user can enter number of existing and new employees and cost to training each of them. Salaries of employees and manager, and number of employee retired along with their packages are also included in this section. The cost part comprises of fixed cost per year and variable cost. The user can enter different levels of units at prices of each unit at these levels. This would allow the user of this excel model to analyze and consider changes in the variable cost as the production increases or decreases. The manufacturing equipment part contains price, shipment and installation cost of equipment. The user can also enter the life and salvage value of machine to calculate Depreciation. The Working capital section includes initial working capital and the percentage of sales in upcoming years. Finally cost of capital and tax rate are also included as input and therefore the user of the model can change these as well and analyze the changes in the cash flows and capital budgeting techniques by changing these variables. CALCULATION & OUTPUT Calculations in the excel have been computed using formulas and command options so that if the inputs are changed then the results of the financial model is still able to reflect whether the project should be accepted or not. The model shows the cash flows for the 5 years and each individual head would be modified for five years. Moreover, the user can calculate the output by calculating each item step by step. The description of each item and their calculations has been explained below. Initial Cost The model first calculates the total cost of the project which is the sum of the price of new equipments along with any installation or shipment cost. So, if more equipment is added, the model is able to adjust the total cost of the project accordingly. No. of Units Produced This is the second item and it is calculated by taking the production section as the input. The model calculates the number of units for five years. The number of units produced would be changed by the model as the price of the product changes because it would impact the demand and supply of the product. Price is estimated to be $179 and at this point the demand and supply is at equilibrium and therefore the produced units are sold. The price and production units are estimated to remain constant throughout the five years. Price Price of the product is given in the input section and if the price is changed then it will be changed in the model accordingly. Sales Sales is calculated by multiplying the number of products sold with the price (Hendricks, 1983). The model calculates the sales of five years by taking the product of number of units each year with its respective price. Cost The cost of the units produced is calculated by considering number of units produced, fixed cost, and variable cost. All the conditions of variable cost are incorporated in calculation i.e. it has been identified that the variable cost of the project would reduce as the production increases, therefore if the production exceeds a certain limit which in this case is 1,000,000 then the variable cost would be reduced to $80 from $109. Moreover, if the production increases to 1,500,000 then the variable cost would further reduce to $50. The model includes these changes in the variable costs. The cost cells are made flexible and so that the changes in the project can be estimated and explained by the model. Advertisement Cost When the cost of the product is calculated, the model then focuses on calculating the advertisement cost. The initial cost of advertisement in the first year has been asked by the model for input along with the other advertisement expense which has been identified at the moment as $7 per unit. Therefore the model is able to calculate the first year by incorporating the number of units as well as the total advertisement expense. Moreover, if the management wants to increase or decrease the growth in advertisement, then the model is able to adjust with the changes accordingly. Depreciation The depreciation is calculated by the straight line method and depreciation expense using straight line method remains the same throughout the life of the asset (Ross, 1986). The model considers the total initial cost along with the salvage value and the life of the project, and depreciation would be calculated accordingly. Employment expense The employment cost considers the cost of training, re-training, salaries of employees, managers as well as retirement packages of each employees. Therefore the employment section covers different types of costs that would be made on the employees. The model considers salary packages for employees and managers different. Also the cost of training employees is also considered differently. The model calculates the total cost by incorporating these heads. The company will be incurring the cost of training and retirement package in the first year only and the salary will be included from the second year, so the model is able to consider these costs accordingly. EBIT The model is able to calculate the EBIT by taking the difference between Revenue and cost plus other operating expenses. The operating expenses include the advertisement expense, depreciation expense and employment expense which have already been calculated and discussed. Tax The tax expense is simply calculated by applying the tax rate i.e. 30% on Earnings before interest and taxes. The tax rate is calculated from year “0” to year “5”. The tax rate can be changed from the input section accordingly, so if the tax rate changes, then the model is able to adjust the earnings accordingly. Add back Depreciation After calculating tax, the model adds back the depreciation in Earnings after taxes and interest. The depreciation is added back because it is a non-cash expense (Gitman, and Maxwell, 1985) and it is actually not paid by the company (Jog, and Srivastava, 1995). Net Working Capital The model calculates the net working capital by adding and subtracting the cash inflows and outflows. The working capital has been estimated to increase by 2% of sales annually and the model considers this aspect. So the percentage to sales can be changed from the input section and the model would be able to adjust accordingly. Other items The model also considers the items such as salvage value, Donation Value, Benefit or loss value, and tax deductable value of equipment. Therefore if other costs are incurred then the model is able to consider these cash flows as well. Cash Flow The purpose for calculating all the above items is to find out the cash flows values throughout the life of the project. To find out the total cash inflows and outflows of the investment , the models considers all the cash inflows and outflows of the project Break Even Analysis The model also explains the break even analysis which is the point where the project would yield zero profit (Vickers, 1970). It is important to know the breakeven point of the project because it indicates the minimum amount of revenues or minimum number of units that the company should sell in order to cover its total costs (Brealey, and Myers., 1997). The break even analysis shows the minimum number of units that the company should sell, the minimum price at which the company should sell to achieve the break even as well as the maximum number of units. Capital Budgeting The model also considers the capital budgeting techniques to find out the feasibility of the project and whether the project should be accepted or not. These techniques can only be calculated when the model gives accurate output of cash outflows and inflows. The model first calculates Net Present value (NPV) using the formula in excel. NPV shows the value of the future cash flows in present by discounting it with the interest rate (Fremgen, 1973). The values of cash outflow and inflows along with cost of capital are incorporated in NPV formula. The Internal rate of return is also calculated by the model using IRR formula in excel. IRR shows the interest rate where NPV would be 0 (Gitman, and Forrester, 1977). Similarly, Profitability index and Modified Internal rate of return are calculated using cash flows and cost of capital. Finally the model puts the command in the cell to accept or reject the project on the basis of NPV. So, if the NPV of the project is positive, the project should be accepted and if the NPV is negative then the project should be rejected. Bibliography Brealey, Richard A. and Stewart A. Myers. 1997. Principles of Corporate Finance. New York: McGraw-Hill Companies. Fremgen, James M. 1973. “Capital Budgeting Practices: A Survey.” Management Accounting 54 (No. 11, May): 19-25. Gitman, Lawrence J. and Charles E. Maxwell. 1985. “Financial Activities of Major U.S. Firms: Survey and Analysis of Fortune’s 1000.” Financial Management 14 (No. 4, Winter): 57-65. Gitman, Lawrence J. and John R. Forrester, Jr. 1977. “A Survey of Capital Budgeting Techniques Used by Major U.S. Firms.” Financial Management 6 (No. 3, Fall): 66-71 Hendricks, James A. 1983. “Capital Budgeting Practices Including Inflation Adjustments: A Survey,” Managerial Planning (January-February): 22-28. Jog, Vijay M. and Ashwani K. Srivastava. 1995. “Capital Budgeting Practices in Corporate Canada.” Financial Practice and Education 5 (No. 2, Fall-Winter): 37-43. Peterson, Pamela, and Frank J. Fabozzi. 2002. Capital Budgeting: theory and practice. New York: John Wiley & Sons. Ross, Marc. 1986. “Capital Budgeting Practices of Twelve Large Manufacturers.” Financial Management 15 (No. 4, Winter): 15-22. Shapiro, Alan. 1978. “Capital Budgeting for the Multinational Corporation.” Financial Management 7 (No. 1, Spring): 7-16. Trahan, Emery A. and Lawrence J. Gitman. 1995. “Bridging the Theory-Practice Gap in Corporate Finance: A Survey of Chief Financial Officers.” Quarterly Review of Economics and Finance 35 (No. 1, Spring): 73-87. Vickers, Douglas. 1970. “The Cost of Capital and the Structure of the Firm.” The Journal of Finance 25(1): 35-46. Read More