Capital Budgeting - Coursework Example

The Board of Directors of Lambert Heating Financial Advisor Capital Budgeting May 24, Report Introduction Capital budgeting involves the use of various tools to evaluate future cash flow. Emery et al (2007) indicates that firms evaluate expected cash flow in relation to the initial sums expended in making the investment. The aim of this process is to ensure that investment projects that are undertaken provide added value to the firm. In this regard, it is the responsibility of the relevant personnel to evaluate alternatives in order to determine which project would generate more profits, thereby providing relatively more value to the firm and its stakeholders. In order to determine the feasibility of a project and to allow for comparisons between those that are mutually exclusive several very useful and highly recognised techniques are available. They include: I. Net present value (NPV) II. Internal rate of return (IRR) III. Accounting Rate of Return (ARR); and IV. Simple payback There are three (3) machines that the firm is considering as an investment. They are the Alumier which it currently uses; Big EZ and Cial. The objective of evaluating these investments is to determine which would be more beneficial to the firm. Evaluating Capital Budgeting Tools The NPV, IRR, ARR and simple payback. The advantages and disadvantages of using these methods are noted weaknesses and the relevant calculations to aid in the decision process are noted. Net Present Value (NPV) The net present value takes the time value of money into account and so the cash flows are discounted over the useful life of the asset. A NPV of zero means that the cash flow from the project would be sufficient to repay the initial investment only but would not contribute anything extra. A NPV that is less than zero (negative) would indicate that the funds generated from the project cannot generate sufficient funds to repay the initial investment and therefore should not be undertaken. On the other hand a positive NPV indicates that the project would be able to repay the initial investment and also allow some returns to shareholders (Brigham and Ehrhardt 2005). A positive NPV therefore means that the project under consideration is a worthwhile investment and should be undertaken. This method is very popular but has a number of shortcomings. Titman et al (2011) indicates that in case of capital rationing the NPV is not the deal method as choosing the projects with the highest profitability but not the highest NPV overall when compared to a number of smaller projects. Additionally some of the budget may be left unused. The formula for calculating the NPV is: NPV = CF0 + ((CF1/(1 + r)1) + ((CF2/(1 + r)2) … ((CFn/(1 + r)n) Where, CF0, CF1, CF2… CFn represents the cash flow from year 1 to year n; and r the discount rate . In this case year n is year 6. Table 1.1 in Appendix 1 indicates that provides the Cial machine which is manufactured in Japan would provide the highest NPV. All three projects involve the same initial investment and so capital rationing is not a factor. Internal Rate of Return (IRR) The internal rate of return (IRR) is a widely used tool for evaluating cash flow streams. If it is used in the appropriate manner it can be used to determine which of the three machines represent the best investment. The IRR is defined as that discount rate which equates the present value of a project’s expected cash flows to the present value of the projected cost (Brigham and Ehrhardt 2005). That is, where NPV is equal to zero. Some of the problems associated with the use of IRR is the possibility of conflicting multiple rates of return or in some cases no internal rate at all. However, Hazen (2003) indicates that these multiple rates do not conflict with each other. On the other hand it is regarded by some writers as superior to NPV. Where, The NPV is zero or more the project should be accepted. It is calculated using the following formula: NPV = CF0 + ((CF1/(1 + IRR)1)1 + ((CF2/(1 + IRR)2) + (CF3/(1 + IRR)3) + (CF4/(1 + IRR)4) + (CF5/(1 + IRR)5) = 0. The IRR can also be ascertained by trial and error. That is, trying different rates until the NPV is equal to zero. The calculations for the IRR for the three machines are given Table 1.2 in Appendix 1. The information indicates that the Cial machine has the highest IRR of 14.96% compared top Alumier with 11.86% and Big EZ with 8.23%. Based on this appraisal, the Cial machine is the best option. Accounting Rate of Return (ARR) The accounting rate of return is not considered to be as sophisticated as some other capital budgeting techniques (Gitman 1997). It shows the return on capital employed (ROCE) or the return on investment (ROI). A variety of different formulae are used in its calculation -the most popular being the following: (Estimated Average Profits ? Estimated life of the project) x 100 Other formulae used divide the estimated total profits by the estimated initial investment or the estimated average profits by the estimated initial investment. A number of weaknesses are associated with this method of capital budgeting. They include: The timing of cash flows is not taken into consideration; It focuses on accounting profits rather than cash flows; and It ignores the size of the investment. The ARR calculations are shown n Table 1.3 in Appendix 1. The information indicates that the Alumier machine has the highest ARR of 18% followed by Cial at 16.67% and Big EZ at 6.67%. If this method is to be relied on then the Alumier machine should be selected. However, the other methods like the NPV and IRR show different results and are considered more reliable. Simple Payback The payback period is the length of time that it takes to recover the initial project cost (Brigham and Ehrhardt, 2005). This method is biased towards short term projects as long term projects are considered to be more risky. This method is often used as a preliminary tool to determine the feasibility of the project. One of the disadvantages of this method is that it does not consider how inflation affects the value of money over time. Additionally, it does not allow for ease in the decision making process when projects have the same payback period. Furthermore, it does not take into account the fact that the cash flows may vary and the choice of the cut off period cannot be justified as it is chosen in an arbitrary fashion. The information in Table 1.4 in Appendix 1 indicates that the payback period for the Cal Machine is 5 years while that for Alumier is 6 years. A payback period was not established for the Big EZ machine within the 6 year timeframe. Conclusion The analysis of the four (4) appraisal methods indicates that the Cial Machine is the best option for the firm. The calculations using the NPV and IRR methods which are considered to be superior to the ARR and Payback methods other (Titman et al), indicate that this machine will provide the highest return. However, in terms of the ARR and the Payback the Alumier and the Big EZ machines have the highest ARR and the shortest payback period respectively. Several weaknesses associated with these two methods including the non-inclusion of a discount factor in their calculation suggest that they are unreliable at the very least. To: The Board of Directors of Lambert Heating From: Project Consultant Subject: Project Scheduling Date: May 24, 2013 Report Introduction Projects are the man engine through which businesses ensure growth and profitability for there stakeholders of which employees and shareholders are considered to be of great importance in this regard. The aim of this project is to ensure a successful installation of the machinery while making sure that the employees to be assigned are properly equipped to carry out the task effectively. In fact, Schwalbe (2008).indicates that a project is by nature – temporary, the aim of which is to generate a result that will enable goal attainment. This project is result oriented and consists of a total of has a total of 11 activities. Project Management tools Project management tools including work breakdown structures, Gantt charts and network diagrams are used to schedule and control projects. However, there are other essential activities such as assigning team members to activities and ensuring that they understand what s required of them as well as the importance of getting the work done on time and within budget. Gantt Charts Gantt charts are used to schedule activities and as a means of assigning people to tasks. The Gantt chart in Appendix 2 – labelled Diagram 2.1. The chart shows the normal duration of each activity. The Activities which are labelled A to F are represented by light blue coloured horizontal bars. These bars provide information relating to the start date and end date of an activity. For example, Activity A which is to be completed n 2 weeks is scheduled to start in week 1 on June 3, 2013 and end on June 17, 2013. The Gantt chart indicates that some activities have to be completed before others can start. Network Diagrams Network diagrams are used to control complex projects. The diagram shows that the project will start on June 3, 2013 and end on November 15 2013 – a total of 24 weeks. It shows the earliest start (ES) latest start (LS) times as well as the earliest finish (EF) and the latest finish (LF) times. ES represents the earliest date while EF represents the earliest finish date. EF is found by adding the duration of the activity to the ES of that particular activity. This is described as a forward pass (Heizer and Render 2006). For example, the ES for Activity A which is found in the upper left hand corner of the activity node is 0. When the duration of A shown in the centre of the node below the Activity ID (A in this case) - 2 weeks is added to 0 the result is 2. Therefore, EF is 2. LF is the latest finish date for an activity. The duration of the Activity is deducted from LF to arrive at the latest start. However, when more than one project follows an activity’s LF becomes the latest LS of those to succeeding activities. The process of deducting the duration for LF to arrive at LS is described as a backward pass. In the case of Activity J, LF which is located at bottom right of the activity node is 24 weeks and the duration which s 5 weeks s deducted to arrive at LS. Diagram 2.2 in Appendix 2 shows the Network diagram with normal duration .The critical path which is highlighted in blue is the longest path through the network. The Activities with ID’s B, F, I and K have no slack period and require crashing in order to reduce the time period involved. Table 1 below shows the slack period for each of the 11 activities. Slack Period and Critical Path (CP) Activity Normal Duration Earliest Start (ES) Earliest Finish (EF) Latest Start (LS) Latest Finish (LF) Slack (LS - ES) On Critical Path? A 2 0 2 6 8 6 No B 3 0 3 0 3 0 Yes C 10 0 3 7 10 7 No D 7 2 12 5 15 3 No E 15 2 9 8 15 6 No F 9 3 18 3 18 0 Yes G 7 3 12 10 19 7 No H 4 12 19 15 22 3 No I 5 18 22 18 22 0 Yes J 3 12 17 19 24 7 No K 2 22 24 22 24 0 Yes Table 1 – Slack and CP Table 1 shows a list of the Activities, their normal duration, ES, EF, LS and LF. LS and ES have been used in calculating the slack. LF minus EF would also give the same result. The activities on the critical path are highlighted in bold. Diagram 2.3 in Appendix 2 shows the revised network diagram after crashing the project to facilitate a three week reduction from 24 to 21 weeks. Activities F and I were crashed to facilitate this for a reduction of 2 and 1 week respectively. The cost per day to crash an activity is ?200. Table 2 below show the crash costs and other information. Calculation of Crash Cost Task Normal Duration (weeks Minimum Duration (weeks) Maximum Reduction (weeks) Crash Cost per day (?) Crash Cost for Activities Crashed (Maximum Reduction in days x crash cost per day x number of days) A 2 2 - 200 B 3 3 - 200 C 3 3 - 200 D 10 8 2 200 E 7 6 1 200 F 15 13 2 200 2 x ?200 x 10 = ?2,000 G 9 7 2 200 H 7 6 1 200 I 4 3 1 200 1 x ?200 x 5 = ?1,000 J 5 4 1 200 K 2 2 1 200 Total ?3,000 Table 2 – Highlights of Activities Crashed and Crash Cost Table 2 shows that the cost of crashing the project using Activities F and I is ?3,000. It also shows the maximum duration that s allowable for crashing other activities if that becomes necessary. Conclusion Scheduling and controlling of project activities involves a lot of work. There are several software programs such as MS Project and Open Proj that will facilitate this and therefore make the job easier than when it is done manually as in this case. However, the work does not end here. Continuous monitoring is necessary to ensure that the project is n conformance with the desired standard and that it finishes on time. Therefore, monitoring involves a process of quality control as well as enable facilitate proper time management. These along with proper communication and management of risk will allow for successful completion of this project. To: The Management of Lambert Heating From: Operations Consultant Subject: Minimising the Cost of Procurement Date: May 24, 2013-05-23 Report Introduction Linear programming is used by firms perform analysis of complex activities. T is described as a very powerful tool that helps managers deal with profit maximisation, cost minimisation and product mix issues. In essence it enables optimisation to be achieved in all relevant problem areas. The challenge facing Lambert Heating is that of minimising the cost incurred in obtaining five different boilers from three suppliers some of which offer at least 4 of the 5 boilers. The problem is a minimisation problem and the objective function is stated as follows: Minimise Cost: 300A +480B + 725C Subject to the following constraints: Constraint 1: A ? 1,800 Constraint 2: B ? 800 Constraint 3: C ? 1,000 The problem can be solved both graphically and with the use of equations. In this case Microsoft Excel was used to set up the function and objectives in order to get the results. A, B and C are the quantities of Uno, Duo, and Tre. These are the boilers for which constraints that are specific to a particular supplier exist. The Linear programming set up is shown in Appendix 3. . Appendix 1 Capital Budgeting Tools NPV Calculation for the Three (3) Options   NPV factor (10%) Alumier Machine   Big EZ Machine   Cial Machine Year Cash Flow/(Outflow) Adjusted Cash Flow Cash Flow/(Outflow) Present Value Cash Flow/(Outflow) Present value 0 1 (500,000) (500,000) (500,000) (500,000) (500,000) (500,000) 1 0.909 50,000 45,450 200,000 181,800 150,000 136,350 2 0.826 100,000 82,600 150,000 123,900 150,000 123,900 3 0.751 150,000 112,650 150,000 112,650 150,000 112,650 4 0.683 150,000 102,450 50,000 34,150 150,000 102,450 5 0.621 150,000 93,150 25,000 15,525 100,000 62,100 6 0.564 170,000 95,880 25,000 14,100 50,000 28,200 NPV     32,180   (17,875)   65,650                 Table 1.1 NPV Calculations IRR Calculations for the Three (3)Options Year Alumier Machine   Big EZ Machine   Cial Machine Cash Inflow/(Outflow)   Cash Inflow/(Outflow)   Cash Inflow/(Outflow) 0 (500,000) (500,000) (500,000) 1 50,000 200,000 150,000 2 100,000 150,000 150,000 3 150,000 150,000 150,000 4 150,000 50,000 150,000 5 150,000 25,000 100,000 6 170,000 25,000 50,000 IRR 11.86%   8.23%   14.96% Table 1.2 – IRR Calculations Calculation of ARR for the Three Options   Alumier Machine Big EZ Machine Cial Machine Total Profits after depreciation for 6 years 270,000 100,000 250,000 Average Annual profit after depreciation 45,000 16,667 41,667 Original Cost of Investment 500,000 500,000 500,000 Average Net Book Value over 6 years [(500000 + 0)/2] 250,000 250,000 250,000 Formula for calculating ARR:       ARR = [(45000 ? 250000) * 100)] 18.00% 6.67% 16.67%     Supporting Calculation of Total Profits After Depreciation Years/initial Investment Cash Flow Alumier Cash Flow Big EZ Cash Flow Cial 0 (500,000) (500,000) (500,000) 1 50,000 200,000 150,000 2 100,000 150,000 150,000 3 150,000 150,000 150,000 4 150,000 50,000 150,000 5 150,000 25,000 100,000 6 170,000 25,000 50,000 Total profits after depreciation 270,000 100,000 250,000 Table 1.3 ARR Calculations and Supporting Information Payback Period Calculation   Year Alumier Machine Big EZ Machine Cial Machine Cash Inflow/(Outflow) Cumulative Balances Cash Inflow/(Outflow) Cumulative Balances Cash Inflow/(Outflow) Cumulative Balances 0 (500,000) (500,000) (500,000) (500,000) (500,000) (500,000) 1 50,000 (450,000) 200,000 (300,000) 150,000 (350,000) 2 100,000 (350,000) 150,000 (150,000) 150,000 (200,000) 3 150,000 (200,000) 150,000 0 150,000 (50,000) 4 150,000 (50,000) 50,000   150,000 100,000 5 150,000 100,000 25,000   100,000   6 170,000   25,000   50,000   Payback period   Year 5   Year 5   Year 5 Table 1.4 Payback Period for the Three Options Appendix 2 Project Management Tools ID Description of Activity Time (Weeks) W1 W2 W3 W4 W5 W6 W7 W8 W9 W10 W11 W12 W13 W14 W15 W16 W17 W18 W19 W20 W21 W22 W23 W24 A Order New machinery B Plan new physical layout of factory C Determine changes needed on existing machinery D Receive new equipment E Hire new employee to supervise the operation of the new machinery F Make changes needed to accommodate new machinery G Make changes needed in existing machinery H Train existing employees to use new machinery I Install new machinery J Disassemble old machinery K Conduct employee safety training on new installation Diagram 2.1 Gantt chart Diagram 2.2 Network Diagram with Normal Duration Diagram 2.2 – Network Diagram after Crashing Activities F and I Appendix 3 Uno Duo Tre 0 2.322581 0 Apex 500 750 300 1741.935 >= 1000 Brunswich 725 320 1683.871 >= 800 Centrale 480 775 310 1800 >= 1800 480 725 300 1683.871 References Brigham, E.F and Ehrhardt, M.C. (2005). Financial Management: Theory and Practice. 11th ed. USA: Thomson South-Western Emery, D.R., Finnerty, J.D. and Stowe, J.D. (2007). Corporate Financial Management. 3rd ed. USA: Prentice Hall Hazen, G. B (2003). A new perspective on multiple internal rates of return. The Engineering Economist, 48(1), p. 31 - 51 Heizer, J and Render, B. (2006). Operations Management. 8th ed. New Jersey: Pearson/Prentice Hall Ryan, P and Ryan, G. (2002). Capital Budgeting Practices of the Fortune 1000: How Have Things Changed? Journal of Business and Management, 8(4), p. 282 - 286 Schwalbe, K. (2009). Information Technology Project Management. Sixth Edition. USA, Cengage Learning. Titman, S., Martin, J.D and Keown, A.J. (2011). Financial Management: Principles and Applications. Prentice Hall Read More