Chino Material Systems Inc: Capital Budgeting - Coursework Example

Lecturer: Chino Material Systems Inc: Capital Budgeting - Case 95 It is imperative to bear in mind that capital budgeting helps in determining the rational of accepting or rejecting a given sales project. On the other hand, the concept is crucial in every market setting especially when the target clientele is cautious about the cost implications surrounding the market trends. Thus, the capital budgeting is vital in developing evidence-based criteria for investment decisions (Klein, 1994:1). This paper presents a capital budgeting analysis envisioned to help the sales team of Chino Materials Systems Inc convince GP Manufactures to buy a proposed new machine of higher efficiency, production reliability as well as customer cost saving. In its chronology, the analysis incorporates the aspect of IRR, NPV profile, MIRR, incremental cash flow as well as the impact of investment tax credit. Thus, the paper concludes with a classical decision making rationale inherent in the proposed sale projection. GP Manufacturing Project Cash Flow In the financial data presented for GP Manufacturing, the initial investment outlay refers to the cost of the project which is usually a negative value. Secondly, the depreciation tax savings for each year has been apportioned over six year after which the project will not attract any federal or state taxation. The last component of cash flow statement relates to the projects incremental cash. It reveals that the company is reinvesting its returns at a similar rate to that of the cost of capital; hence the AT Cost Saving remains constant over the investment period. Net Present Value From the GP Manufacturing project’s cash flow, the NPV is determined to be $21,396.19. With this in mind, this positive NPV suggests that the envisaged project will add value to the company and thus the acquisition decision is viable. It is however possible to find that, the NPV of this company may differ from that of other companies with respect to Chino’s positions. This is attributed to the fact that different companies have varied costs of capital, thus justifying the possibility of diverse NPV. Proposed IRR The proposed IRR for this project is 14.42% as derived from Excel computations. It is worth noting that there could be more than one IRR, hence the need to ‘guess-function’ the rationale. In this case the IRR is greater than the 12% cost of capital for GP manufacturing. As such, it will be of good prudence to invest in the proposed new project presented by Chino Materials Systems Inc. Payback period for GP Manufacturing From empirical accounting basis, the payback herein refers to the span of time in years which the company needs in order to recover the initial cash outlay. In this case, the PP for GP Manufacturing is 4.76 year. Typically, the concept of payback period relates only to the duration beyond which an investment may start generating positive return otherwise known as profits. However, exclusive use of payback period as a financial investment tool is never satisfactory since the concept does not provide explicit rational in capital budgeting on which an investment decision can be make. Besides, it lacks prerequisite basis on which comparison can be made against other proposed ventures. Chino Materials System Inc has several machines with varied properties including long useful life, efficiency, cost and reliability. In that case, the PP concept could be useful in determining which product to invest in. For instance, a machine with a short productive life may force the investing company to examine if it has a shorter PP. If not, then it will be inappropriate to invest in such project. On the other hand, a cost effective machine with long productive life would be suitable even if it has a longer payback period. That notwithstanding, the reciprocal of PP can only be useful as an evaluation tool to invest in products of long life to estimate the expected rate of return. Modified Internal Rate of Return With regard to the federal-plus-stare tax rate, GP manufacturing pays about 36percent to the money invested in the initial project. On the other hand, the predetermined cost of capital stands at 12%. Thus, the MIRR for this company is determined to be 13.07% owing to the fact that its investment modality extends for 8 years as derived from the project’s net cash flow. The difference between MIRR and IRR is that the former presents only a single figure for the rate of return. However, several rates may exist when dealing with IRR since a project might have both positive and negative variables. On the other hand, IRR makes a typical presumption that all positive returns are reinvested in the business at the same pre-set rate for the initial cost of investment. Thus, IRR presents a rather inflated perception of the expected return while MIRR gives a more realistic picture (Derreck, 1991: 46). Therefore, the MIRR is a better connotation for the expected performance of the project as it shows the general attractiveness of a specified project. Profitability Index PI The profitability index PI for GP manufacturing currently stands at 1.6812 over an eight year period. This is the ration of discounted cash flow to the cost of capital invested in a given project. Primarily, this indicates that GP Manufacturing is earning 1.68 for every present value dollar invested. When the absolute value of PI is greater than 1, the investment is worth accepting. When NPV is negative, IRR is less than the cost of capital, MIRR is significantly lower that the internal rate of return and when the PI is less than 1; the company will definitely consent to the same decision of rejecting a project. On the other hand, the reverse holds true for purposes of accepting a proposed project. Should there be any conflict, the NVP take preference in determining the investment decision (Derreck, p72). This is due to the fact that NPV is based on the returns of dollar invested which is predisposed to both the internal competencies and the externalities of the market forces. If the federal government reinstated the ITC at a reduced rate of 10%, the impact is that he project will have a greater profit margin. Besides, the profitability prospects thereto will increase as a result of the ITC-driven reduction in the cost of production. However, the internal rate of return will not vary with any significant margin. In the event that Chino Material Systems Inc sells to GP Manufacturing a short life product of low quality, the standing NPV will decline to $6,250. This emanates from an assumed 12% cost of capital ($150,000) and a 1 year useful life span in which the cash inflow for year 1 is estimated at $175,000 (Klein, p2). The IRR will therefore be 16.67%. If the cost of capital is high and the internal rate of return is low, then an investment conflict is bound to occur since there prospects might to be commensurate to the value of such project. Thus, it might become hard to decide whether to accept or reject the project even if the profitability index is greater than 1 for mutually exclusive or independent projects. Where the cost of savings differs from the projected level, it calls for consideration of other factors such as the profitability index as well as the NPV. As such, the decision criteria will be passed on whether the difference is positive or negative. Negative shift would be a rational basis for rejecting the project while the positive shift will be sufficient grounds for supernormal profits. Suppose the company borrows some capital at 12 per cent to purchase the proposed machined at $285,000 and the prospective rate of return is 14%, the MIRR will vary significantly. For one, MIRR will increase to about 14.01% which is relative consistent with the initial IRR. Besides, the cost of savings will be slightly lower than the projected rate. Thus, the project will be viable. Whereas the process of demonstrating sensitivity test might be tedious for each client, it is an important concept that every sales executive should be conversant with. It creates the clarity of facts where a client might want to see how the changes occur. With a large closeout alternative, the NPV will be $51020.41 while the IRR will change to 10.56%. MIRR on the other hand will be 13.32% which is slightly diverse for the internal rate of return given that the cost of capital is 12 per cent and the reinvestment rate is 14%. These events indicate that a project with a large closeout value is risky venture. Works cited Derreck, A. Economic Evaluation of Investment Projects, (3rd Ed). Icheme Publishing, 1991 Klein, L. Chino Material Systems: Capital Budgeting Case 95. Stamford, CN: Cengage Learning, 1994. Read More