Capital Budgeting and Sales Mix Decisions

This assignment delves into the financial analysis of a landscaping business. It examines the impact of altering the sales mix on profitability, comparing the current strategy with one that favors 3-year-old trees over 1-year-old trees. Additionally, it evaluates two proposed equipment purchases using ARR and IRR, highlighting the importance of NPV in capital budgeting decisions. The analysis culminates in a recommendation for the most suitable equipment option based on financial metrics.

Business Analysis and Interpretation
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Question 1
a) The monthly cash budget for the Landscaping Business for the three months ended 30
September 2016 is presented below:
Particulars July August
Septembe
r
Beginning cash balance $26,500 -$74,000 $61,800
Add: Budgeted cash Receipts
Fees
$1,40,00
0
$1,60,00
0 $2,00,000
Proceeds from sale of surplus non-current
assets
$1,00,00
0
Total cash available for use
$1,66,50
0
$1,86,00
0 $2,61,800
Less: Cash disbursements
Salaries and wages $70,000 $70,000 $70,000
Supplies $8,500 $9,200 $12,000
New Equipment
$1,20,00
0
Purchase of plants $42,000 $45,000 $61,000
Total disbursements
$2,40,50
0
$1,24,20
0 $1,43,000
Budgeted ending cash balance -$74,000 $61,800 $1,18,800
b) In case the business decides to lease the new equipment instead of buying it, the cash
changed cash budget is presented below:
Particulars July August
Septembe
r
Beginning cash balance $26,500 $36,000 $1,61,800
Add: Budgeted cash Receipts
Fees
$1,40,00
0
$1,60,00
0 $2,00,000
Proceeds from sale of surplus non-current
assets
$1,00,00
0
Total cash available for use
$1,66,50
0
$2,96,00
0 $3,61,800
Less: Cash disbursements
Salaries and wages $70,000 $70,000 $70,000
Supplies $8,500 $9,200 $12,000
New Equipment $10,000 $10,000 $10,000
Purchase of plants $42,000 $45,000 $61,000
Total disbursements
$1,30,50
0
$1,34,20
0 $1,53,000

Budgeted ending cash balance $36,000
$1,61,80
0 $2,08,800
From the above we see that if the company leases the new equipment, the ending cash
balance is positive for all the three months whereas in the initial arrangement, when the
company had bought the equipment and paid for it in the month of July, the ending cash
balance of July was negative as cash payments were more than the cash receipts. It is very
important for any business to maintain a positive cash balance at any given point in time
because cash is required on a day to day basis to run the business operations smoothly. If the
cash balance is negative, the company will have to borrow money from the bank and this
borrowing will attract interest which is a finance cost to the company (Ross, Hillier,
Westerfield, & Jordan, 2012). Moreover as a result of leasing, the cost of the equipment will
be evenly divided throughout the year.
Hence, it is better to lease the new equipment in order to maintain a positive cash balance for
all the three months.
Question 2
Break even points in units = fixed costs / contribution margin
Fixed costs = $402,800
Contribution margin = selling price per unit – variable cost per unit
Particulars
1 year
old tree
2 year
old tree
3 year
old tree
Total
Selling price $20 $28 $45 $93
Variable cost per unit $12 $18 $27 $57
Contribution margin per unit $8 $10 $18 $36
Therefore, total break- even point in units = $402,800 / $36
= 11,189 units
For per product break-even units, the total break-even units are divided between the products
on the basis of the percentage of product sale in total sales.
1 year 2 year 3 year Total

old tree old tree old tree
Selling mix 125000 75000 50000 $2,50,000
Percentage share 0.5 0.3 0.2 1
Per product break-even point:
1 year
old tree
2 year
old tree
3 year
old tree Total
Percentage share 0.5 0.3 0.2 1
Break even units 5,594 3,357 2,238 11,189
b) The profit before tax for Landscaping business is presented below:
1 year old
tree
2 year old
tree
3 year old
tree Total
Selling price $20 $28 $45
Variable cost per unit $12 $18 $27
Contribution margin $8 $10 $18
Selling mix 1,25,000 75,000 50,000 250,000
Contribution margin $10,00,000 $7,50,000 $9,00,000 $26,50,000
Fixed costs $4,02,800
Profit before tax $22,47,200
c) In order to increase its profitability, the company is looking at increasing the sales of 3
year old trees while reducing the sale of 1 year old trees, resulting in an increase in fixed
costs. The new profit before tax for the above change is calculated below:
New sales mix
1 year old
tree
2 year old
tree
3 year old
tree Total
Sales mix 40% 30% 30% 100%
Selling units 100,000 75,000 75,000 250,000
The profit before tax for the new initiate is given below:
1 year old
tree
2 year old
tree
3 year old
tree Total
Selling price $20 $28 $45
Variable cost per unit $12 $18 $27

Contribution margin $8 $10 $18
Selling mix 100,000 75,000 75,000 250,000
Contribution margin $10,00,000 $7,50,000 $9,00,000 $26,50,000
Fixed costs $4,52,800
Profit before tax $24,47,200
Looking at the above analysis, we do not recommend that the Landscaping business should
go ahead with changing the sales mix by increasing the sales of 3 year old trees and reducing
the sale of 1 year old trees as the profit margin has remained almost the same. The before tax
profit margin for initial sales mix was 32.8% whereas the new sales mix has a profit margin
of 32.7%. So we see there is no change in the profit margin. Though the total profits have
increased by $200,000 but even the fixed costs have increased by $50,000. Thus the resulting
increase in profits does not justify the increased fixed costs and hence the business should
stick to the old sales mix.
Question 3
a) Currently the company is relying on two capital budgeting techniques ARR and IRR to
decide between purchasing one of the two pieces of equipment. ARR is the accounting profit
of the investment whereas IRR is the rate at which the NPV of the project is 0. Both ARR and
IRR do not use discount rate of the investment in its calculations. However, it is very
important to discount the future cash flows to present to incorporate the effect of inflation
into the investment analysis. Generally companies use cost of capital as their discount rate if
the risk of investment is similar to the existing business risks. Discount rate is required in
calculation of NPV which is the most useful technique in capital budgeting analysis. Only if
NPV of an investment is positive, other measures like ARR and IRR can be considered
(Houston & Brigham, 2016).
b) No, the owner cannot rely solely on ARR and IRR to decide on the purchase of new
equipment. Net present value (NPV) is the most effective capital budgeting technique used
when deciding on a project. In order for an investment to be acceptable, the NPV of the
project should be positive which means the cash inflows should be more than cash outflows.
A positive NPV means the project is profitable. If the NPV of the project is negative with
other capital budgeting techniques like ARR and IRR exceed the minimum required rate, still

the project will be unacceptable because the NPV is negative. So in order to make a decision
with regards to the investment in equipment, calculation of NPV is extremely important and
the NPV should be positive. ARR does not consider the time value of money as the cash
flows are not discounted, also ARR does not consider the cash flows and terminal value.
c) If all the calculated returns exceed the entity’s minimum rate, then we would recommend
equipment B as it has a higher IRR. The investments are mutually exclusive, and even though
both are acceptable as per the capital budgeting techniques, however since only has to be
selected, we will consider IRR for making an investment decision. IRR is a better risk
measuring technique as it considers the time value of money and all the cash flows are taken
into consideration (Luckett, 1984) . For mutually exclusive projects, it is advisable to use IRR
and project with a higher IRR is selected. Equipment B has a higher IRR at 18% as compared
to Equipment A which has an IRR of 16%.
Bibliography
Houston, J., & Brigham, E. (2016). Fundamentals of Financial Management. Australia: Cengage
Learning US.
Luckett, P. (1984). ARR vs. IRR: A REVIEW AND AN ANALYSIS. Journal of Business Finance and
Accounting.
Ross, S., Hillier, D., Westerfield, R., & Jordan, B. (2012). Cash Management. McGraw Hill.