Capital Budgeting and Resource Allocation - Report Example

Capital Budgeting and Resource Allocation Capital budgeting decisions are critical every firms that has the objective of maximizing the value of their investments. Finance managers must therefore make a detailed evaluation on whether to invest in particular projects that will bring cash flows to the company and which financing decision to make. In doing this analysis, management must consider the various costs it will incur and the savings it will make once such investments are completed and cash flow benefits starts flowing to the company. In addition, most of the investment decisions involves huge sum of money hence careful consideration of the benefits of the project should be made. In making capital budgeting decisions, management should consider the present value of the future expected cash flow using reasonable rates of return. Moreover, the assumptions made in making such considerations must the sound, reasonable and realistic. Further, the capital budgeting decisions should consider the different methods of financing and ensure that the best option is selected and that the selected financing choice will increase firm’s value and investors return (Holland & Torregrosa, 2008). Important to note is that the evaluation will only take into consideration items that result in actual cash flow. None cash flow items like depreciation and goodwill amortization will not be incorporated in the evaluation. Bob Prescott, the controller of Blue Ridge Mill is faced with the decision of advising the company on whether making an investment of adding a new on site Longwood woodyard will bring benefits i.e. reducing the operation costs and increasing revenues. The costs savings and additional revenues must be sufficient to cover the cost that will be incurred in acquiring the additional capital of 18 million dollars. We shall thus perform an analysis of the investment to help make a decision on whether the investment should be made. The net present value approach of capital appraisal will be used in the determination of whether the investment is worth the minimum return required by the investors. Using this approach, future expected cash flows will be discounted at the cost of capital which in our case is the hurdle rate of 15%. Only actual items of cash flows will be used in the calculation. The variables used to appraise the project are discussed below. Capital outlay This represents the capital that will be used build the new longwood woodyard. The total amount of cash flow required for the investment is $ 18 million which will be invested in two phases of $ 16 million in the first year and $ 2 million in the second year. This is cash outflow. Cost savings on investments With the new project, the management expects a cost reduction. Cost reduction represents an actual reduction in the cash out flows through incurring of additional expenses or reducing the costs of the doing business (Shim & Siegel, 2012). Cost savings therefore represents cash inflow and has been discounted at the cost of capital. Cash inflow from additional capacity With the additional investment, Blue Ridge Mill will make additional sales hence earn additional cash flow from the proceeds. As a result, the profit before tax has been computed to be used in the computation of the tax expense at 40%. Tax paid is a cash flow to the business. The cost of sales to be determined at 75% of the revenue has been used in the calculation of the profit on sales. Other costs incurred have been used to help determine the profit before tax. Since the additional investment will have no salvage value after the sixth year, depreciation expense has been computed for the investment period of six years. Depreciation has been computed after the completion of the project construction. The depreciation expense has been considered in arriving at the profit before tax. To arrive at the actual cash inflow or out flow as a result of the additional sales value, depreciation expense has to be added back. Depreciation expense does not result in actual cash follow and is thus omitted in the evaluation using the NPV approach. Increments in working capital With the increase in additional capacity, the working capital of the company is expected to increase. An increase in working capital in items such as inventory and debtors represents cash out flows. This will be included to arrive at actual cash flows. Redemptions of the working capital In the year 2013, management expects to redeem the working capital increase in the period. Redemption of working capital will mean additional cash inflow in the year 2013. In addition, management expects to redeem 10% of the $ 18 million invested in the year 2013. This represents cash inflow and is will therefore be added as a cash inflow item. Discounting of the net cash inflows or cash flows To help appraise on whether to accept the investment or reject the proposal, the cash flows will be discounted at the cost of capital which has been represented by the hurdle rate (Sharma, 2010). Hurdle rate is the lowest rate of return that investors will be willing to accept of their investment. This rate will thus be used in the discounting the cash flows. Capital Budgeting Calculations                 Capital Outlay 18,000,000.00               Tax rate 40%               Depreciation rate 6 Years               Hurdle rate 15%               Year Formula 2007 2008 2009 2010 2011 2012 2013 Capital Outlay A (16,000,000.00) (2,000,000.00) - - - - - Costs savings on investments B - 2,000,000.00 3,500,000.00 3,500,000.00 3,500,000.00 3,500,000.00 3,500,000.00 Revenue from the investments C - 4,000,000.00 10,000,000.00 10,000,000.00 10,000,000.00 10,000,000.00 10,000,000.00 Cost of goods sold D=75%*C - (3,000,000.00) (7,500,000.00) (7,500,000.00) (7,500,000.00) (7,500,000.00) (7,500,000.00) SG&A E=5%*C - (200,000.00) (500,000.00) (500,000.00) (500,000.00) (500,000.00) (500,000.00) Depreciation F=18,000,000/Number of years - (3,000,000.00) (3,000,000.00) (3,000,000.00) (3,000,000.00) (3,000,000.00) (3,000,000.00) Profit Before tax K= C+D+E+F - (2,200,000.00) (1,000,000.00) (1,000,000.00) (1,000,000.00) (1,000,000.00) (1,000,000.00) Tax @ 40% of net profit L=40%*K - (880,000.00) (400,000.00) (400,000.00) (400,000.00) (400,000.00) (400,000.00) Profit after tax M=K-L - (1,320,000.00) (600,000.00) (600,000.00) (600,000.00) (600,000.00) (600,000.00)                   Actual cash flow from operations (Add back depreciation) N=M+F - 1,680,000.00 2,400,000.00 2,400,000.00 2,400,000.00 2,400,000.00 2,400,000.00 Increments in working capital O=10%*C - (400,000.00) (1,000,000.00) (1,000,000.00) (1,000,000.00) (1,000,000.00) (1,000,000.00) Redemption of working capital P - - - - - - 5,400,000.00 Capital recoverable Q - - - - - - 1,800,000.00 Net cash inflow/(Outflow) R=Q+P+O+N+B+A (16,000,000.00) 1,280,000.00 4,900,000.00 4,900,000.00 4,900,000.00 4,900,000.00 12,100,000.00 Present value Interest factor at 15% S=1/(1+15%)^n 1.00 0.87 0.76 0.66 0.57 0.50 0.43 Present value of the cash flows T=R*S (16,000,000.00) 1,113,043.48 3,705,103.97 3,221,829.54 2,801,590.90 2,436,166.00 5,231,163.91 Net present value of the investment U 2,508,897.80             Evaluation From the analysis, it has been recommended that the company adopts the project. The project has a positive net present value of $ 2.5 million. It therefore means that investors will get value on the investments as the rate of return is above 15%. Management of Blue Ridge Mill should therefore accept the project. Conclusion Capital appraisal process, plays a critical role in the performance of a company by either maximizing the value of the project or reducing investments worth. In undertaking the process, it is critical for any company to consider the method of financing. Management has the option of either using debt of equity to finance the additional costs. They will have to consider the cost of each sour of financing in order to identify its advantages and disadvantages. For the case of Blue Ridge Mill, the expansion will increase the fortunes of the company and should therefore be accepted. References Holland, J., & Torregrosa, D. (2008). Capital budgeting. Washington, D.C.: Congress of the U.S., Congressional Budget Office. Sharma, N. K. (2010). Business finance. Jaipur, India: ABD Publishers. Shim, J. K., & Siegel, J. G. (2012). Budgeting basics and beyond (4th ed.). Hoboken, N.J.: Wiley. Read More