BTA Machine and Tools - Appraisal of a Capital Expenditure Project - Example

BTA Machine & Tools Appraisal of a Capital Expenditure Project Introduction BTA Machine and Tools is a medium-scale private company located in Brisbane, specializing in machine and tool manufacturing and services. It was founded by husband and wife William and Teresita Anderson, also known as Bill and Terry Anderson (BTA). The small start-up has expanded into two other cities – Gladstone and Newcastle, where partners have expanded their business to meet a growing local demand. In order to bolster production to meet the new demand, three alternative projects are being contemplated which are intended to replace the currently outdated technology and increase production capacity. The three projects have different implications on the number of people needed to operate the machines, and vary in costs and capacity. Evaluating Capital Expenditures Choosing among capital expenditure projects should not rely solely on financial assessment. It is also important to undertake a subjective evaluation of each of the projects, in terms of its suitability for the macro-environment. An examination of the PEST (political, economic, social, and technological) conditions will determine which of the firms, if any, must be excluded by environmental conditions, or which would prove exceptionally suitable to these conditions. A risk assessment is another pre-requisite to determine which of the projects may pose extraordinary or undue risk for the company or the workers who shall be involved in the installation or operation of the new machinery. Incremental analysis shall be employed in this study, which requires discounting the existing financial data reflected by current operations, and instead rendering judgment based on the analysis of changes introduced by each project. Incremental analysis includes only the financial data that would vary in the future as a result of adopting each of the possible alternatives; all current data that are foreseen to remain unchanged are not included in the analysis (Weygandt, Kimmel & Kieso, 2010, p. 299). The accounts that appear in the next tables are the changes expected, based on estimates by the principal owners of the corporation, spouses Bill and Terry Anderson. Alternative projects Project A involves the purchase of a machine, the price and installation of which amount to 110,000 during year 0. This capital expenditure is depreciated over the life of the project, which is 8 years, and since there is no salvage value the annual increase in depreciation expense is 13,750, using the straight line depreciation method. The project mechanises some of the production functions, and as a result of adopting this Project, fewer people will need to be hired. This results in a corresponding reduction in labour expense that gradually increases through the years as the operation becomes more efficient. Adoption of Project A does not foresee any change in revenues, cost of sales or operating expenses, other than the change in depreciation and labour expenses. The incremental accounts pertaining to Project A are shown in the next two tables. Since the increase in depreciation expense and decrease in labour expense have a cumulative effect on the net taxable income, there is a change in net income after tax after application of the 30% income tax rate. If the depreciation expense, which is a non-cash expense, is added back into the net income after tax, then the cash flow resulting from the adoption of Project A is obtained. The cash flow stream for the duration of Project A shall be used in the non-accounting capital expenditure assessment techniques Similarly, the incremental accounts for Project B are shown in the next two tables. Project B has a much smaller purchase and installation cost of 45,000 which comprises its initial investment. The resulting change in depreciation expense is an increase of 4,500 per year for the 10 years that constitute the life of Project B, using straight-line depreciation method. Project B has an assumed increase in revenues, owing to the fact that the business owners expect production level to actually increase. The expected increase in the units produced, multiplied by the average price of the products, yields an estimate of the incremental revenues to be realised. The labour expense, however is expected to adjust only once to its new level, and remain constant for the rest of the machine’s life. Project C is the third alternative being considered by the business owners. The incremental changes in the accounts of the company given the likelihood of adopting Project C are shown in the table following. Like Project A, Project C does not assume that revenues shall change as a result of its adoption. The adoption of Project C, such as the two other projects, will enable the firm to reduce labour requirements and therefore reduce labour expenses in the conduct of operations. The company expects to achieve increasing savings in labour costs each year due to the gradual phase-out of redundant positions. The initial investment for Project C is 60,000, and since the life of the project is six years, additional depreciation costs amounting to 10,000 per year will be incurred by applying straight line depreciation to the capital expenditure. Financial Assessment of Alternative Capex Projects Accounting Rate of Return (ARR) The accounting rate of return is a capital budgeting measure that does not rely on cash flows, but on the annual accounting profit calculated by deducting cost of sales and operating costs expected to be incurred from the expected revenues the project is expected to acquire (Crosson & Needles, 2010). The ARR is calculated by the formula: The use of the ARR makes the choice of depreciation method important, because if different depreciation conventions were used among the different projects, that fact would make the resulting comparisons unreliable because the net income per year would be higher or lower based on the depreciation method applied (Groppelli & Nikbakht, 2006). Since the straight line method was applied for all projects, then comparison of their ARR would be reliable. The ARR calculated for each project is shown in the following table, specifying the accounting income after tax and the initial capital outlay incurred per project. ARR Evaluation Project A Project B Project C Ave. Accounting Income 15,575 2,800 15,750 Initial Investment 110,000 45,000 60,000 Accounting Rate of Return 14.2% 6.2% 26.3% Based on the accounting rate of return, the most profitable project is Project C at 26.3%, followed by Project A at 14.2% and Project B at 6.2%. This is compared to the weighted average cost of capital (WACC), which is the average cost of each dollar of financing, whether such financing is raised by borrowing or equity (Besley & Brigham, 2011). The profit that the firm makes on its investment should exceed the WACC for the company to realize a real gain on its investment (Pratt & Grabowski, 2010). In this case, the company’s owners provided the information that BT’s WACC is 12%, with a capital structure of 35% debt financing and 65% equity financing. Based on this criterion, the projects whose ARRs are within the acceptable limit are Projects A and C; Project B, with only 6.2% accounting rate of return fails to meet the minimum 12% needed by the firm to meet the financing requirements. Cash flow Stream In order to calculate for the other evaluation methods, it is necessary to set up the cash flows which are presented in the next table. Cash flows are calculated by adding back depreciation and other non-cash expenses to the accounting net income after tax, since these expenses did not really entail an out-of-pocket cash disbursement (Lewis & Insua, 2006; Whittington, 2012). In the cash flow stream, negative cash flows indicate cash disbursements while positive cash flows signify cash receipts. Payback Period The payback period is the simplest and one of the more often resorted to capital budgeting techniques. It determines when the cash receipts would have covered the cash outflows, functioning as some sort of breakeven indicator – when cash receipts equal cash disbursements (Chandra, 2008; Satzinger, et al., 2008). The advantage to using payback period, aside from its simplicity, is that it provides a ready measure of risk concerning the timing of cash flows. Large multinationals or companies in fast-changing industries may quickly assess the risk to recovery of their investment through payback. The drawback to this method is that it does not take into account the time value of money (Groppelli & Nikbakht, 2006; Shim & Siegel, 2007). In the foregoing table, the amounts per year indicate the outstanding portion of the initial investment which has still not been matched by cash inflows; the negative value marks the year when payback is completed. The sooner the project reaches payback, the lower the risk, which works to the company’s advantage. In this case the best choice is Project C (3 years to payback), followed by Project A (4 years) and Project B (7 years). Discounted Payback Period The discounted payback period is a refinement of the payback period in that it incorporates time value of money considerations. The present value of cash flows are used, and the amounts on the table indicate the portion of initial investment still outstanding at yearend. The cash flow streams shown in the following table uses the WACC of 12% as discount rate. By this criterion, Project C leads with payback in year 4, followed by Project A with payback in year 6. Project B should not even be considered, because even at the end of its life (10 years) the project still has not recovered its initial investment. Net Present Value and Profitability Index The next succeeding techniques shall make use of discounted cash flows, thus the present values of projects’ cash flow streams, discounted by the WACC of 12%, are given in the following table as basis for calculation. From the foregoing table, the net present value or NPV is calculated as the sum of each cash flow stream, which is the value of the project at present. The other indicator, the profitability index or PI, is calculated by taking the ratio of the present value of cash inflows over cash outflows. The projects, to be acceptable, must have a positive NPV and a PI of at least 1.0. Among mutually exclusive alternatives, the project with the highest positive NPV and highest PI above 1.0 is the preferred choice (Razgaitis, 2009; Tapiero, 2004). The following table shows the computed NPV and PI for the three projects. Indicators Project A Project B Project C NPV (16,979) (19,280) 8,683 PI 0.8456 0.5716 1.1447 The more stringent criteria of NPV and PI (compared to payback period, discounted payback period and even accounting rate of return, shows that of the three projects, only Project C is acceptable, since it is the only project with a positive NPV and a PI above 1.0. It is therefore the only project, based on these indicators, which is able to exceed the cost of its capital financing and would therefore provide a real return to its investors. Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR) Last is the IRR and the MIRR. The IRR is the project’s discount rate at which the sum of the present value of inflows is equal to the present value of all costs incurred throughout the life of the project (Brigham & Ehrhardt, 2011). Its advantages are that it focuses on cash flows, it takes into account the time value of money, and it is easy to compare with other projects and the firm’s hurdle rate and does not rely on an estimated discount rate (Gallagher & Andrew, 2007). In the table following, of the three projects, Project As and C both exceed the hurdle rate (12%) of the company, although Project C is higher than Project A and would therefore be preferred. The MIRR is ‘used to estimate potential financial profitability of investment projects in relative terms’ (Shestopaloff, 2009, p. 273). The MIRR takes into consideration the cost of investment and interest on reinvestment of cash, and it must be compared to the firm’s hurdle rate (Fabozzi & Peterson, 2003). Among the projects, Projects A and C both meet the hurdle rate and are thus acceptable, but Project C exceeds the firm’s WACC by a wider margin and is therefore the better choice. The fact that MIRR exceeds cost of capital by the widest margin indicates that it is the project which has the greatest chance of earning a return that exceeds expectations. Conclusion In light of the foregoing assessments it is only Project C which has met the acceptance criteria for all the capital expenditure assessment criteria earlier evaluated. It is therefore recommended that BTA Machine & Tools implement Project C in its next capital expenditure. References Besley, S & Brigham EF 2011 Principles of Finance, 5th edition. Mason, OH: South-Western Cengage Learning Brigham, EF & Ehrhardt, MC 2011 Financial Management: Theory and Practice. Mason, OH: South-Western Cengage Learning Chandra, P 2008 Financial Management: Theory and Practice, 7th edition. New Delhi: Tata McGraw-Hill Crosson, SV & Needles, BE 2010 Managerial Accounting. Mason, OH: South-Western Cengage Learning Fabozzi, F J & Peterson, P P 2003 Financial Management and Analysis, 2nd edition. Hoboken, NJ: John Wiley & Sons., Inc. Gallagher, TJ & Andrew, JD 2007 Financial Management: Principles and Practice, 4th edition. Freeload Press. Groppelli, AA & Nikbakht, E 2006 Finance, 5th edition. Hauppauge, NY: Barron’s Educational Series, Inc. Lewis, RP; Insua, NM 2006 Business Income Insurance Disputes. Aspen Publishers. Pratt, S P & Grabowski, RJ 2010 Cost of Capital: Applications and Examples, 4th edition. Hoboken, NJ: John Wiley & Sons., Inc. Razgaitis, R 2009 Valuation and Dealmaking of Technology-Based Intellectual Property. Hoboken, NJ: John Wiley & Sons, Inc. Satzinger, JW; Jackson, RB; & Burd, SD 2008 Systems Analysis and Design in a Changing World, 3rd edition. Chicago, IL: CCH Wolters Kluwer Shestopaloff, YK 2009 Science of Inexact Mathematics: Investment Performance Measurement. Toronto, Canada: AKVY Press. Shim, JK & Siegel, JG 2007 Handbook of Financial Analysis, Forecasting & Modeling, 4th edition. Hoboken, NJ: John Wiley & Sons, Inc. Tapiero, C S 2004 Risk and Financial Management: Mathematical and Computational Methods. Chichester, West Sussex: John Wiley & Sons, Ltd. Weygandt, JJ; Kimmel, PD; & Kieso, DE 2010 Managerial Accounting: Tools for Business Decision Making. Hoboken, NJ: John Wiley & Sons, Inc. Whittington, OR 2012 Wiley CPA Exam Review 2013, Business Environment and Concepts. Hoboken, NJ: John Wiley & Sons, Inc. Read More