Capital Budgeting Plays a Big Role - Essay Example

? Finance Analysis Table of Contents Introduction 3 Research on Model Design 3 Capital Budgeting Model and the explanation of the Outputs 4 Conclusion 6 References 7 Introduction Capital Budgeting plays a crucial role in the business decisions of organizations. Generally, organizations make their investment decisions on the basis of the returns expected from those investments (Jaffe & et al, 2004, p. 167). There are number of methods that are widely used by companies to evaluate their available investments options. In this study, it was required to compute the Net Present Value of a project for a given company and make a recommendation on whether the project is worthwhile or not. The NPV of a project is the difference between the present values of its cash inflows and its cash outlays. The NPV technique makes use of the discounted cash flow method and discounts the cash flows at the rate of the cost of capital (Smart & Megginson, 2008, p. 261). Additionally, this paper includes designing a capital budgeting model that can be used to evaluated similar projects. Research on Model Design The conventional use of financial models is to evaluate the financial feasibility of a proposed investment. Such models can be utilized to investigate the various investment alternatives that are available, in order to choose the most viable one. Generally financial models are designed to assess a particular capital budgeting project. Capital budgeting choices are supposed to be based on cash flows, instead of accounting profits. Additionally it is the incremental cash flows that are applicable. In general, a project is undertaken if the NPV of the incremental cash flows generated from it is found to be positive. However, there may be instances when a Company has multiple projects to choose from but due to budget constraint, the firm’s management might not be able to select all the projects that have a positive NPV. In such cases, the projects having higher values of NPV are opted over those which have inferior NPV values. When the projects are mutually exclusive, the one having the highest NPV is chosen and the others rejected (Gallagher & Andrew, 2007, p. 270). It is known that spreadsheets are suitable and very useful device that are utilized in the assessment of capital projects. The most common methods used in these models are the NPV and the IRR, though other methods like payback period and accounting return are also used. The review of literature revealed that the most popular and publicly available capital budgeting models were the one created for assessing investments in forestry. Some of these models comprise of the FARMTREE model, Agro Forestry Estate model, Australian Farm Forestry Financial Model and the Australian Cabinet Timbers Financial Model (Dayananda et al, 2002, pp. 237-240). These models are designed to evaluate forestry investments and owing to their large scale and exclusive requirement are complicated in nature. On the other hand, the model prepared for the appraisal of the MP3 player project has been built according to its customized requirements and hence best suited. This model is user friendly and even a layman would be comfortable using it for appraising similar projects. The model has been so created, that even if the input variables and the associated relationships are changed, the model would be able to accommodate the changes. Capital Budgeting Model and the explanation of the Outputs For the calculation of the NPV of the new MP3 player production project that is being considered by the Company, it is crucial to determine the cash flows related to the project. The cash flows can be grouped as follows: Initial capital outflow Operating cash flow during the project’s life (in this case: 5 years) Cash flow during the terminal year of the project The initial capital outflow of the company included the training cost, the retirement package, the working capital requirement and the equipment cost, i.e. $158,701,000. The components of the operating cash flows in the next five years have remained constant, other than the advertising cost, which had gradually decreased and the working capital cash flow. The NPV was then computed by discounting the operational cash flows by 10%, which was the expected rate of return. Since the NPV of the project is negative it should be ideally rejected. It can be inferred from the capital budgeting model that the MP3 player production project would not be profitable it were to be priced at $119 and if 1,150,000 units of it were sold per year in the next five year period. From the break even analysis it can be observed that if the MP3 Player were priced at $179 each, the number of units sold required to attain the breakeven point is 714,528. While if 1,000,000 MP3 players were to be sold the least price at which the business would breakeven is $151 per unit. Conclusively, a sensitivity analysis was carried out by varying the price per unit and the corresponding sales volume of the MP3 players, in order to obtain the optimal net present value. It can be inferred from the sensitivity analysis that the NPV of this project can be maximized when 600,000 units of MP3 players are sold at the rate of $339 each. Conclusion Business organizations have to continually make investments in their operations and business activities for the continuation of their business. As a result, the investment made by a company in its assets and projects is termed as its capital investment. A company has to pick its investments thoughtfully in order to obtain satisfactory rate of return and produce rational cash inflows. Furthermore, at any given point of time a company has to decide between two or more investment opportunities (Horngren, 2008, p. 254). Thus, it is crucial that business organizational appraise their investment options carefully. A capital budgeting model has been prepared which can be utilized to appraise, compare and choose between various investments opportunities. Accordingly, this capital budgeting would assist in taking investment choices and determining if a project is worth undertaking. It was observed from the analysis that at the present price per unit and corresponding expected sale volume, the project would not be fruitful for the company. In order to optimize the returns from the project, the product should be priced at $339 per unit for which the likely expected sales volume would be 600,000 units. References Dayananda, Don. & et al. Capital Budgeting: Financial Appraisal of Investment Projects. UK: Cambridge University Press, 2002. Gallagher, Timothy & Andrew, Joseph. Financial Management. US: Freeload Press Inc, 2007. Horngren, Charles, Introduction to Management Accounting. UK: Pearson Education. 2008. Jaffe, Jeffery. & et al. Corporate Finance. India: Tata McGraw-Hill Education, 2004. Smart, Scott & Megginson, William. Corporate Finance. UK: Cengage Learning, 2008. Read More