Capital Budgeting Methods for Project Evaluation - Business Case Study 2

This report evaluates the feasibility of a new project for Pinto using capital budgeting methods such as NPV, IRR, PBP, and profitability index. The report includes sensitivity tests and risk assessments to determine the project's feasibility under different scenarios. The conclusion recommends that Pinto should invest in the new plant and equipment, but also highlights the importance of considering assumptions on projected sales volume and prices.

Assessment 3: Business Case Study 2

EXECUTIVE SUMMARY
Capital budgeting can be used to evaluate the feasibility of a new project such as
investment in new equipment, plant or replacement of a product line, machine etc.
(Accounting Explained, 2017).
There are several methods that can be used in capital budgeting. These methods
include the payback period (or PBP), discounted payback period, the internal rate of
return (or IRR), the net present value (or NPV) and profitability index. These methods
are quantitative and may be used in a combination or alone.
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TABLE OF CONTENTS
EXECUTIVE SUMMARY.........................................................................................................................1
TABLE OF CONTENTS...........................................................................................................................2
CHAPTER 1 : CAPITAL BUDGETING..................................................................................................3
1.1 Introduction – Project Evaluation Methods.................................................................................3
1.2 Discount Rate.................................................................................................................................3
1.3 Assumptions....................................................................................................................................4
1.4 Risk Assessment -Base Scenario................................................................................................5
1.5 Project Feasibility under Base Scenario.....................................................................................5
1.6 Risk Assessment -Sensitivity Tests.............................................................................................6
1.7 Project Feasibility under Sensitivity One.....................................................................................6
1.8 Project Feasibility under Sensitivity Two.....................................................................................6
1.9 Project Feasibility under Sensitivity Three..................................................................................6
1.10 Conclusion and Recommendations...........................................................................................7
References...................................................................................................................................................8
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CHAPTER 1: CAPITAL BUDGETING
1.1 Introduction – Project Evaluation Methods
Following significant competition from overseas manufacturers, the management of
Pinto is considering investing into a new project that will move the company towards a
new market that will be more risky than its current operations. The new product line is
valued at $15million and has a useful life of five years.
The purpose of this report is to provide a recommendation as to whether Pinto should
invest in the new product line.
There are several capital budgeting techniques that may be used to assess Pinto’s
project. They include quantitative and qualitative methods. Examples of quantitative
methods are the payback period (or PBP), discounted payback period, the internal rate
of return (or IRR) , the net present value (or NPV) and profitability index.
The general rules as to whether to accept or reject a project are as follows-
 If the profitability index is greater than 1, then the project should be accepted.
 If the NPV is larger than zero, then the project will be profitable and should be
accepted.
 If the PBP and discounted PBP is short and/or less than the project’s time
horizon, then the project should be accepted.
 If the IRR is larger than the company’s hurdle rate, then the project is profitable
and should be accepted.
1.2 Discount Rate
A discount rate is the smallest return a company will expect to earn on an investment. A
company’s weighted average cost of capital may be used as the company’s discount
rate (Tucker, 2009).
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As per the information given, Pinto currently has a 10% weighted average cost of
capital. Therefore, for purposes of capital budgeting, Pinto’s discount rate will be 10%.
1.3 Assumptions
The following assumptions have been made under the Base Scenario:-
Investment $15,000,000
Volume sales year 1 200,000
Selling price year 1 $75
Sales growth volume years 2 and 3 50%
Sales Growth volume years 4 and 5 -50%
Growth in Selling price 3%
Production costs 60% of selling price
Growth in SG&A per year from year 2 5%
Income tax rate 30%
Asset life 5 years
Depreciation $3,000,000
In addition to the base scenario, three sensitivity tests will be modelled by varying the
assumption levels under the selling price and volume.
Sensitivity One
Under this scenario, let’s assume the growth in years 4 and 5 increase at 50%. All other
assumptions remain the same.
Sensitivity Two
Under this scenario, it is assumed there is no growth in the selling price. All other
assumptions remain the same.
Sensitivity Three
Under this scenario, we assume there is no growth in the selling price and growth in
years 1 and 2 increase at only 10%. All other assumptions remain the same.
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1.4 Risk Assessment -Base Scenario
The table below shows the after tax cash flows for Pinto over 5 years should they invest
in the new plant under the Base scenario.
T 0 1 2 3 4 5
Investment -$15,000,000 $0 $0 $0 $0 $0
CF due to
change in net
working capital
-$3,000,000 $0 $0 $0 $0 $3,000,00
0
Opportunity
cost of lost
rental
-$175,000 -$175,000 -$175,000 -$175,000 -$175,000
Net income $0 $1,400,000 $3,654,000 $7,153,755 $2,252,79
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-$291,840
Add back
depreciation
$0 $3,000,000 $3,000,000 $3,000,000 $3,000,00
0
$3,000,00
0
ATCF -$18,000,000 $4,225,000 $6,479,000 $9,978,755 $5,077,79
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$5,533,16
0
Using a discount rate of 10%, the NPV is calculated as $5,596,502. The table below
shows the results of the other four capital budgeting measurements.
NPV 5,5m
Payback Period 3.38
Discounted Payback Period 3.17
Profitability Index 1.31
IRR 21.1%
Table 1-1: Base Scenario
1.5 Project Feasibility under Base Scenario
From the analysis above, it is evident that the project appears feasible. This is because
 NPV is positive
 PBP is less than 5 years,
 IRR is greater than 10%,
 The project’s profitability index is larger than 1.
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Therefore, Pinto should proceed with the project.
1.6 Risk Assessment -Sensitivity Tests
The table below summarizes the results for the additional scenarios based on the
revised assumptions.
Scenario 1 Scenario 2 Scenario 3
NPV $25,857,794 $4,524,554 -$2,315,366
Payback period 3.38 3.46 4.74
Discounted payback period 3.17 3.27 4.74
Profitability index 2.44 1.25 0.87
IRR 42.3% 19.2% 4.6%
1.7 Project Feasibility under Sensitivity One
From the analysis above, it is evident that the project appears feasible. This is because
 NPV is positive
 PBP is less than 5 years,
 IRR is greater than 10%,
 The project’s profitability index is larger than 1.
Therefore, Pinto should proceed with the project
1.8 Project Feasibility under Sensitivity Two
From the analysis above, it is evident that the project appears feasible. This is because
 NPV is positive
 PBP is less than 5 years,
 IRR is greater than 10%,
 The project’s profitability index is larger than 1.
Therefore, Pinto should proceed with the project
1.9 Project Feasibility under Sensitivity Three
From the analysis above, it is evident that the project is not feasible. This is because
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 NPV is negative
 PBP is large,
 IRR is less 10%,
 The project’s profitability index is less than 1.
Therefore, Pinto should not proceed with the project
From the results of sensitivity analysis, we observe that if the projected sales volumes
are not met and/or the selling price is low, the project may end up being unprofitable.
Therefore, the project success depends heavily on the assumptions used for sales
volume and price
1.10 Conclusion and Recommendations
Given that under the base scenario, the NPV is positive, Profitability index is more than
1 and the IRR is higher than the cost of capital, then the project is profitable. Therefore,
we recommend that Pinto should invest in the new plant and equipment.
However, we do not live in a perfect world and the actual results may be better or worse
than the expected outcome. For example, in this case, we can observe that if the sales
projections and selling price are not met, then the NPV will drop thus making the project
not feasible. As a result, Pinto should take into consideration that the assumption on the
projected sales volume and prices plays a vital role.
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References
Accounting Explained. (2017). Capital Budgeting. Retrieved September 2017, from Accounting
Explained: http://accountingexplained.com/managerial/capital-budgeting/
Tucker, J. (2009). How to set the hurdle rate for capital investments. Retrieved from
https://www.eprints.uwe.ac.uk/11334/1/Tucker_2009_QFinance_book_chapter.doc
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