Comparison of Net Present Value, IRR and Payback Period in Capital Budgeting

Capital budgeting is a crucial decision-making process for any business. The assignment highlights the importance of considering both profit and cash when making investment decisions. It also emphasizes the difference between the two, with cash being the actual money available to the company and profit being the accrued amount. The Bristol Project, which involves taking over an existing plant, has a higher net present value compared to the Leed project. The assignment also discusses working capital management, highlighting the need for EFL to recover outstanding amounts from customers and eliminate unused inventory at its London site. Finally, the assignment concludes that the Net present value method is the most suitable approach for evaluating investment decisions.

Business Finance – Excellence Electrics Ltd
Business Finance
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Business Finance – Excellence Electrics Ltd
Executive Summary
EEL is not having enough cash and there is a big difference between cash and profit because of
dues from customers and lined up inventory at the London site of business. EEL should try to
recover the dues and stop adding inventory at London site, as there is not work going in there,
and consume the inventory there by using it or selling it. This report details out the steps of
capital budgeting process and why it is important to keep formal documentation of it. It states the
different methods of capital budgeting and why the chosen method Net Present value is
considered for selecting or not selecting a project.
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Business Finance – Excellence Electrics Ltd
Table of contents
Introduction ……………………………............................…………..
…………………………………………....................... Page 4
Findings
1.1 Profitability, cash flow, need for working capital and how working capital can be
managed ......
…………………………………………………………………………………………………..
.......... Page 5
1.2 Capital budgeting stages, Application and analysis ......
…………………………………………………………………………………………………..
........... Page 7
Conclusion
2.1 Difference between profit and cash, working capital application, and how it can be
improved
.
……………………………………………………………………………………………………....
..................... Page 10
2.2 Conclusion of Capital budgeting steps and which method gives the best answer
.
……………………………………………………………………………………………………....
..................... Page 10
Recommendation
……………………………………………………………………………………………………....
..................... Page 12
References
............................................................................................................................................................
..................... Page 13
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Business Finance – Excellence Electrics Ltd
Introduction
This report is prepared to provide the information about the difference between the cash flow and
the profitability of EFL and how these are shown in the accounts of it. It also puts impact of
working capital on the company and how it is used in the company and how it can be improved
or financed so that it can be used effectively as per the needs of EFL. It also states, which
method of capital budgeting is useful in selecting a project and what are the steps for capital
budgeting appraisal.
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Business Finance – Excellence Electrics Ltd
Findings
1.1 Profitability, cash flow, need for working capital and how working capital can be
managed.
a. Three factories are operated by EFL and generating turnover of £35 million.
b. Ownership is Dieter – 25% and 75% between Hild, Angela and Ragnar.
c. Operating profit for last year £5 million before interest and taxes
d. Debt increased to £18 million which was earlier £15 million.
e. £1.5 million owed by company by the customers Canterbury Cookers and £2 million of
payment is outstanding amount from customer Radio Formidable
f. Due to the disputes, large stock of inventory is lined up at the company’s London site
which Mr. Dieter thinks is the required level of stock needed after the dispute is solved
and is unwilling to put pressure on the customers to make due payments.
i. What is profitability and what is Cash Flow
There is a big difference between profit and cash. Profit can be defined as the amount
of money which a business makes after deducting all the expenses incurred by it from
the revenues earned, whereas cash is the amount of money which a business has in
hand to pay the expenses. There can be instances where the business may make good
profit but is unable to perform good as it does not have enough cash. There may be
much reason for not having enough cash, out of which the common one is the amount
owed by the customers and making payment for expense which is not being used
currently.
The other reasons being as per the American Express Article published in year 2013
which can affect the cash or profit or both:
- New products: When these are launched, it carries warranty repairs or product
recall, whereby customer service department has to work more, leading to
customer dissatisfaction as there may be no expansion in the staff as per the
growth of the product. This increases expense for repairs, refunds, etc.
- Over spending: During the success period of the business, spending decisions in
the light of overly optimistic becomes over. For example: purchasing costly
machineries, etc.
- Problems related to operations- Where volume increases, there may not be
immediate action plan to overcome it, which can lead to increase in unexpected
expenses.
- HR problems: Dissatisfaction among the staff due to change of supervisors, or
payroll problems may make the business deliver the products after the given
period of time, which can lead to extra penalty or expense.
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Business Finance – Excellence Electrics Ltd
ii. Need for working capital and how it is used
Working capital as the name suggests means, capital needed for working. It is an
important term for business, as it is useful to know what is needed for day to day
operations. There are two concepts for it. One is quantitative and the other on is
qualitative. Quantitative is defined as the capital which is gross working capital.
Qualititative concept focuses on the source to finance capital. It calculates working
capital as current assets excess over current liabilities. In the event of inadequate
working capital, the company can face many difficulties such as:
- Production department gets affected, as there are not enough funds to cater it
needs.
- Less liquidity results into damaging credit worthiness.
- The day to day expenses can hamper because of lack of cash for paying repair and
maintenance.
- The shareholders will get fewer dividends as the funds are less or no.
- It may result into insolvency of the company because of non-payment of debts
and expenses.
iii. How the working capital can be managed by the company effectively.
There are multiple ways to manage the working capital:
- Alternative funding: It means that there must be some other source of fund which
must be there to help operating expenses go easy Other than raising funds through
debts, the business can have finance through crowd funding, invoice discounting,
etc.
- Making expenses visible: there are many such expenses which a company can
avoid such as late fees, penalty, travel expenses, etc.
- Management of stock: Stock is one of the most important parts of production,
without which production cannot be carried easily. Over stock or under stock,
both are harmful to the business. Overcrowding stock will make increase chances
of wastage, theft, storage expenses, etc. and the amount of purchase money is also
blocked. It will not be realized, unless they said inventory comes into production
and it gets sold.
- Managing payments or receipt effectively: Payment to suppliers and receipt from
customers should be timely met. With suppliers discount can be negotiated so that
the total cost of purchase decreases. In case of receipt from customers, proper
invoices should be maintained. Fees or penalty may be charged to them for late
payments, to increase the receipt of dues from them.
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Business Finance – Excellence Electrics Ltd
1.2 Capital budgeting stages, Application and analysis
a. Dieter is thinking to invest in either of the two: Leeds or Bristol.
b. Leeds venture involves construction from scratch costing £10m and operating for 9 – 10
years.
c. Bristol venture involves taking over an existing out dated plant costing £6 million with
useful life 5 – 6 years.
i. Stage of Capital budgeting to evaluate which project is worthful
- Identifying and evaluating the potential opportunities: This is the first step of
capital budgeting. A company have different options available to them with
different durations and cost involves and different clauses attached to it. In this
step, the company seeks the potential options which are available to them.
- Second step is to estimate the costs attached to the options identified in step first.
It involves summing up the costs which will be incurred to implement the project.
This is done by researching both internal environment and external environment.
- Estimation of the benefits to be derived from the options selected: There must be
some cash flow or benefit being derived from the options available. List them all
by identifying the cash flow for an option by either watching the similar projects
in the industry which were proved successful or where the cash flows are certain,
then such amount to be taken into consideration, and in cases where the cash flow
is not fixed or can’t be determined with similar projects, then company must make
best possible way to ascertain the benefit amount of that option.
- Assessment of Risk: Almost every project involves risk. It can be because the
project is a fresh option which no one has availed, or will stand to lose, if the
project does not worked out, or the estimated benefit is less than the estimated.
After ascertaining the risks involved, the best option can be identified.
- Implementation – After ascertaining which option is to be followed or start with,
an implementation plan is needed. This plan includes the payment method for the
selected project, method of tracking the costs of the project, and how the cash
flows will be recorded. It also mentions the starting date of project and estimated
ending date of project.
Benefit of keeping the capital investment appraisal formal, helps in comparing the
performance of the project actually some with the estimated results. It also mentions
the details of the person responsible for the implementation, the targets to be
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Business Finance – Excellence Electrics Ltd
achieved, and the steps to achieve it. The start date and end date of project. It helps in
knowing each and very detail of the project selected, so that it is easy to compare and
know how the project is implemented and to justify any errors.
The main appraisal method to identify which project is to opted are:
NPV: in this method the cash flows, the discounting factor, the period of lease or
project, cost of the project is to be known to calculate the total net present value of the
project. This method is used widely as it is easy to compute, and is used largely by
all. It calculates the present value of the future cash flows and is based on the
assumption that the present value of any fore value is less that it. It is not trusted in
case of the projects which are completely.
IRR method: It involves identification of cash flows, period of project, self assumed
discounting factor, project; s cost and estimated rate of return at which NPV is zero.
In this method rate of return is calculated at which the Net present value is zero. This
will give a rate of return at which there will be no profit or no loss made by the
project and therefore it can be compared with the discounting factor applicable on the
projects, can state how much scope is there to choose the method and to avail risk.
Payback period: This method is used to ascertain the payback period of the project. It
involves the cash flows, total life of the project, and cost of the project. In this method
no time value of money is calculated. Instead it is seen that in how much time a
project will payback its cost and other expenses. The shorter the period, the better the
project is. This method is good for those companies, which are small in size and is
more liquid. Where the cash flows are uneven, this method is not suitable in such
place.
ii. The potential application to the project considered by EEL.
Net present value method
Let’s assume that the cash flows are even in both the projects. Taking it as £2 million
for each year. Cost of equity is 10%.
Project Leed :
Time period – 10 years
Formula = Present value of project – Cost of the project.
Net present value = £1/(1+0.1)1 + £1/(1+0.1)2 + £1/(1+0.1)3 + £1/(1+0.1)4 +
£2/(1+0.1)5 + £2/(1+0.1)6 + £2/(1+0.1)7 + £2/(1+0.1)8 + £2/(1+0.1)9 + £2/(1+0.1)10 -
£10 million
= 1.818 + 1.6528 + 1.502 + 1.3660 + 1.2418 + 1.1288 + 1.0262 + 0.933 + 0.848 +
0.771 - £10 million
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Business Finance – Excellence Electrics Ltd
= £12.2876 million – £10 million
= £2.2876 million
Bristol project
Time = 6 years, cost of equity assumed to be 10%, cost of project is £6 millionNet
present value = £2/ (1+0.1)1 + £2/ (1+0.1)2 + £2/ (1+0.1)3 + £2/ (1+0.1)4 + £2/ (1+0.1)5
+ £2/ (1+0.1)6 - £6 million
= 1.818 + 1.6528 + 1.502 + 1.3660 + 1.2418 + 1.1288 - £6 million
= £8.7094 million – £6 million
= £2.7094 million
IRR method
As the cash flows are considered to be equal, the internal rate of return is zero for
both the projects.
Payback period
Project Leed: The cost of investment is £10 million, time period 10 years. It will take
10 years time to payback on the assumption that cash flows are equal.
Project Bristol: The cost of investment is £6 million, time period 6 years. It will take
10 years time to payback on the assumption that cash flows are equal.
iii. Analysis of method suitable to make decisions
In the light of the three methods Net present value, IRR and payback period, two
methods are not creating any difference for both the projects. These two methods are
IRR and Payback period. On considering the Net present value method, it is seen that
on the assumption that cash flows are equal, Net present value of Bristol Project is
more than the Project Leed.
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Business Finance – Excellence Electrics Ltd
Conclusion
2.1 Difference between profit and cash, working capital application, and how it can be
improved.
i. Difference between profit and cash.
There is variance between cash and profit, as the former is the money which is
present in hand, and the latter is accrued amount of net profit. As profit and cash are
two separate terms and cannot be merged with each other, a business earning good
profit does not mean that it has enough cash.
In case of EEL, the two main customers of it are Canterbury Cookers Ltd and Radios
Formidable SA. Alone Canterbury is owing £1.5 million of amount for the large
orders which it placed and for the other customer Radio formidable, there is a dispute
going on due to which £2 million amount is withheld by it. It clearly shows that
though the profit made by EEL is £5 million, but £3.5 million is the amount which is
still not received. This shows that the company is short of £3.5 million of cash.
ii. Application of working capital for EFL and causes for it.
In respect of the business, the current assets include debtors. The customers are
having outstanding balance of £3.5million which is a lot of amount and can affect
working capital completely to finance the operating needs.
There is not enough cash in the hands of business to cater the expenses.
iii. Steps to improve EFL’s working capital requirement.
In EEL, there are two major problems of getting money blocked because of which the
working capital is not managed properly.
One is dues from customers and other is inventory. Amount due from customer is
£3.5 million which is a large sum. The area of work suspended in company’s London
site, suspended the inventory, due to which it is getting lined up. The company should
insist the customers to pay the balance amount with them soon.
As for the inventory, no more should be purchased for the London site, and any other
inventory available there must be consumed.
2.2 Conclusion of Capital budgeting steps and which method gives the best answer
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Business Finance – Excellence Electrics Ltd
i. Capital budgeting process involves five steps consisting of identification of various
alternatives available to the business, cost attaché to such investment options, cash
flows to be derived from such options, any risk attached to such options, and last one
is Implementation. It is important to maintain document of the same for future and
comparison purpose reasons. The method used to evaluate budgeting decisions is Net
present value, internal rate of return and last one is Payback period.
ii. On applying all the three methods, only Net present value method can be used as
internal rate of return and payback period is zero and full time period respectively.
iii.Net present value method is most appropriate to make decision in relation to which
option to be considered. If one is to be considered for investment, then Bristol project
is more suitable in which an existing plant is to be taken.
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Business Finance – Excellence Electrics Ltd
Recommendations
Cash and profit both are different. Cash is net of receipts over payment, whereas profit is net of
income over expenses. Being profitable does not mean that the cash system of the company is
sound. To make it sound, the difference of amount between the profit and cash should be
minimized. The major points which create difference between ash and profit are dues from
customers and unused inventory at London site. The company should insist the customers to pay
the balance amount on time and take necessary actions to recover the amount left with them.
Both of these are current assets and also form working capital. There may be no difference in
working capital amount when calculate with debtors or cash, as both are part of current assets,
and the amount shifting from debtors to cash will make no change in the net amount. However,
unused inventory will make false decision on working capital.
The company should pay attention in recovering its receipts from both the customers and should
eliminate the inventory stocked up at London site by either using it or selling it.
Bristol project can be considered to be pursued as this project tends to generate more profit by
£2.7094 million - £2.2876 million = 0.4214 million
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Business Finance – Excellence Electrics Ltd
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