Capital Budgeting Techniques for Investment

This solved assignment examines the role of capital budgeting in business decision-making and analyzes two project proposals (Reading Venture and Bristol Venture) using NPV, payback period, and IRR. It compares the profitability of each venture, ultimately recommending Reading Venture based on its higher IRR and faster payback period. The document emphasizes the importance of capital investment techniques for enhancing firm value.

Root & Cook Ltd

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
Part 1................................................................................................................................................1
1. Different terms of accounting.............................................................................................1
2. Concepts that affect business financial results...................................................................2
3. Recommendations to improve the financial position by managing working capital.........3
Part 2................................................................................................................................................4
1. Explaining the term capital budgeting and process............................................................4
Merits and demerits of investment appraisal methods...........................................................5
2. Calculation of investment options......................................................................................7
3. Recommendation to select investment venture................................................................11
CONCLUSION..............................................................................................................................11
REFERENCES..............................................................................................................................11

INTRODUCTION
Finance is required in every business so that it may be able to carry out day-to-day tasks
in effective way. Present report deals with RCL LTD which is engaged in producing garden
tractors and ride-on lawn movers. Report discusses importance of working capital and how it
should be managed to carry out tasks. Moreover, WCC is also explained with example. Apart
from this, capital budgeting process and techniques are discussed relevant for expansion purpose.
In relation to this, investment appraisal techniques such as payback period, IRR, NPV are
calculated for selecting best options available to company.
Part 1
1. Different terms of accounting
Profit: Profits are the surplus for firm in which all the expenses are deducted from the revenues
effectively. Profit is also a base for tac calculation which describe the overall picture of firm
efficiently. Profits such as net profit operating profit and gross profit. All of them in a positive
numerical form represents the performance of business operational activities and produce
information. The absence of profit affect the cash flow. In addition to this, business has incurred
expenditures more than income, then it is called net loss. This implies that organisation has to
initiate control over expenses to generate sufficient profits.
Cash flow: Cash flow refers to the inflow and outflow of money which will be done by Root and
Cook Ltd. Cash flow management is important for the business in order to manage and control
different operational activities such as operating cost, salary paid to workers, purchasing
inventories and taxes etc. Cash flow in positive manner defines the increasing liquid assets and
negative cash flow define decreasing liquid assets. On the other hand, cash outflow means
business makes payment to suppliers, rent for premises and all expenditures are allocated under
accounts payables.
DIFFERENCE BETWEEN PROFIT AND CASH FLOW
Profit Cash flow
Profit is determined by deducting all the
variable and fixed expenses from revenue and
thus, the net income of Root and Cook Ltd is
Cash flow accounts are for a specific period in
order to derive it effectively. Cash flow
deduction are made from the cash inflow and
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derived in efficient way. outflow.
There are some company obligations that it
should make profitability in order to attain
effective cash position.
It can be said that firm can be profitable if it
has an inadequate cash flow which may be
insolvent as short term obligation are not
created in a stipulated time period.
Profits scope is wider than the cash flows that
firms need effective net income in order to get
better position in liquidity.
It can be said that cash flow has a narrow scope
and dependent on business ability in order to
make profits which will help to pay liabilities
easily.
2. Working capital: Working capital is very crucial for the firm in order to manage and control
its daily operational activities. Working capital calculated from current assets minus current
liabilities. Working capital also help Root and Cook Ltd to determine its ability towards
achieving the desired goals and short term obligations (Damodaran, 2016). There are various
sources of working capital such as long term loans, net income, stakeholders funds and sale of
capital assets effectively. It is important particularly as it includes accounts payable, receivables
and inventory which should be ideally used by business so that it may be able to pay off
liabilities and liquidity and solvency position may be strengthened effectively.
3. Working capital changes affects the cash flow
Changes in working capital affects the cash flow and specifically operational activities.
Positive cash flow describe that business have sufficient working capital to meet the short term
requirements and objectives. On the other hand, negative cash flow affect the liquidity position
of firm. Thus, it can be said that working capital and cash flow are connected to each other.
2. Concepts that affect business financial results
It can be said that working capital has a important role in firm. In respect to this, it is
necessary for RCL Ltd to increase its solvency and liquidity position in order to pay liabilities
which will also help to achieve the short term requirements of the firm such as cash needs.
Business is able to provide strengthen to working capital by quickly converting the net assets
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into cash which will help to increase the liquidity aspects (Mathuva, 2015). The conversion cycle
is known a Working capital cycle.
The working capital cycle consists purchasing inventories from which firm utilise and
payments will be received from consumers in the market by selling finished products on the
credit basis. RCL Ltd has 30 days initial time to pay the amount of raw material purchased.
Average creditors' payment period calculated in such way:
Inventory on an average / sales of the concern 365
8000/22000*365 = 132 days
This defines that business will consider 132 days to sell inventories. Debtors collection
period assessment will be calculated in days that debtors outstanding are 20000 and the credit
sales is 80000. The formula to calculate debtors collection period will be:
 Debtors/sales made on credit*365
 20000/80000*36 = 91 days
It can be said that the above calculation will help to calculate the WCC effectively. It is
clear that creditor will be paid off within 30 days and stock will convert into sales within 132
days. Finally, the receivables will be converted into cash within 91 days time period effectively.
The calculation for WCC will be:
 Stock turnover + Receivables turnover – credit period
 132+91-30 = 193 days.
Thus, it can be justified that RCL Ltd will require 193 days in order to convert its net
assets into liquid cash successfully and effectively. The cash will be received by the firm within
193 days. Business should garner more capital which will help to enhance the solvency and
liquidity position efficiently. This will also help to manage the working capital successfully and
in effective manner.
3. Recommendations to improve the financial position by managing working capital
It can be said that the working capital has a vital role in the business. It will help to pay
liabilities and also carry the day to day operations. Working capital calculated from current
assets minus current liabilities. Working capital also help Root and Cook Ltd to determine its
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ability towards achieving the desired goals and short term obligations. There are various sources
of working capital such as long term loans, net income, stakeholders funds and sale of capital
assets (de Almeida and Eid Jr, 2014). It is important particularly as it includes accounts payable,
receivables and inventory which should be ideally used by business so that it may be able to pay
off liabilities and liquidity and solvency position may be strengthened effectively.
Apart from this, business should purchase raw materials from suppliers in order to offer
discount on it. This will help firm to improve its liquidity and solvency position. Funds can be
also retained from better working capital management. The most important aspects to improve
the working capital is effective control over variable and fixed expenses which will help to
generate positive cash flow within business effectively and efficiently. Moreover, it is required
that business should examine interest obligations so that instalments can be reduced by making
early payments and also rate of interest can be analysed. Minimising these payments will add to
enlargement of working capital in effective manner (Ehrhardt and Brigham, 2016). Firm can also
eliminate extra and waste expenses in order to provide strengthen towards working capital
management. RCL Ltd is responsible for managing the payments received from customers in the
market. This will help to clear outstanding from customers.
Improve accounts receivables: Accounts receivables are outstanding and must be collected by
firm in a specific time manner in order to motivate customers in the market by offering them
incentives towards the payments effectively.
Improve accounts payables: The management of payment process should be evaluated by firm
in order to manage the cash flow. For an example, business is able to change the supplier if he is
unable to negotiate the price or better payment option towards the operational activities
effectively.
Thus, better working capital management will help business to operate their daily operational
activities effectively and in efficient manner. This will also help to increase the profitability
which leads towards achieving goals and objectives.
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Part 2
1. Explaining the term capital budgeting and process
Capital budgeting is effective technique in the business for selecting adequate long term
assets so that organisation may be able to generate revenue with much ease. Capital budgeting is
used to effectively analyse investment options in terms of risk associated with it. Moreover, it is
also useful in assessing profitability aspect of new project so that adequate returns may be
produced and business may be benefited. Main purpose of this technique is to maximise
operation The process of capital budgeting is discussed below-
Identification
Identification is the first stage in capital budgeting process in which several proposals are
made and RCL Ltd can invest in the same for expansion purpose (Fokkema, Buijs and Vis,
2017).
Evaluation
This is the second stage which deals with evaluation of new project so that it may yield
benefits to RCL Ltd. Project is evaluated in terms of organisation's objective to earn revenue.
Selection
This is next stage in which proposals are scrutinised and effective project is selected. At
this stage, business finally selects that project yielding maximum benefit.
Implementation
This stage is second last stage which deals with implementation of selected project
yielding good returns. In this stage, various resources are initiated so that project may be
completed within timely manner.
Monitoring
This is the last stage which deals with monitoring of project implemented by RCL Ltd so
that budgeted results can be compared with actual one and corrective actions can be taken in the
event of shortcomings or variances.
Merits and demerits of investment appraisal methods
Payback period
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This investment appraisal method is effective one for RCL Ltd as it clarifies to company
in how many years project will yield returns. This help company to select that project which
provide less time to yield results. It is recommended that less the payback period, company
should invest in the same (Drover and et.al, 2017).
Merits
1. It is easy to compute and interpret results quite effectively.
2. It is useful method which evaluates risk associated with the project and business is
benefited by it.
Demerits
1. Payback period is not suitable as it does not provide profitability aspect of new project
and clarifies only time period within which project will impart returns.
2. It ignores concept of time value of money and is the main disadvantage of this method.
NPV (Net Present Value)
NPV is quite useful investment appraisal method which provides clarity to RCL Ltd in
terms of profitability of project. More the NPV, better for company to invest in the same. Thus,
NPV is important method providing effectiveness of project.
Merits
1. It is quite useful for RCL Ltd as it provides information about profitability element
while assessing project.
2. NPV is useful as it considers time value of money quite effectually and correct
decisions can be made by the company.
Demerits
1. It is not suitable for the company as it considers cost of capital which is a rough
estimate and results may be inaccurate on concentrating on such basis.
2. It is not useful for comparison when two projects are mutually exclusive.
IRR (Internal Rate of Return)
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IRR is effective capital investment technique to assess and forecast profitability aspect of
investment. It uses NPV of cash flows and as such, project can be effectively evaluated
(DeBoeuf and et.al, 2018).
Merits
1. It is useful as it considers concept of time value of money while assessing
attractiveness of project
2. It is simple for computation and results can be interpreted with much ease.
Demerits
1.IRR is unsuitable to compare two projects which are mutually exclusive in term of
time, size etc.
2. It is not useful as it discounting rate which is based on rough estimation and conclusion
drawn on such basis may be inaccurate.
2. Calculation of investment options
Reading Venture
Computation of NPV
Year Net Cash flows
Discounting
factor @ 10%
Discounted Cash Flow
(DCF)
0 20000000
1 7500000 0.909 6818181.81818182
2 8000000 0.826 6611570.24793388
3 8200000 0.751 6160781.36739294
4 8400000 0.683 5737313.02506659
5 9000000 0.621 5588291.90753239
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6 9200000 0.564 5193160.15649475
7 11000000 0.513 5644739.30053777
8 12000000 0.467 5598088.5625168
9 12500000 0.424 5301220.22965606
10 13000000 0.386 5012062.76258391
98800000 57665409.3778969
Initial Investment 20000000
NPV 37665409.3778969
Payback-period
Year Cash flows
Cumulative Cash Flow
(CCF)
0 20000000
1 7500000 7500000
2 8000000 15500000
3 8200000 23700000
4 8400000 32100000
5 9000000 41100000
6 9200000 50300000
7 11000000 61300000
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8 12000000 73300000
9 12500000 85800000
10 13000000 98800000
Total cash flows 98800000
Initial
investment 20000000
0.2024291498
IRR
Year Cash flows
0 -20000000
1 7500000
2 8000000
3 8200000
4 8400000
5 9000000
6 9200000
7 11000000
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8 12000000
9 12500000
10 13000000
IRR 40.85%
Bristol Venture
Computation of NPV
Year Net Cash flows
Discounting
factor @ 10%
Discounted Cash
Flow (DCF)
0 16000000
1 5000000 0.909 4545454.55
2 5500000 0.826 4545454.55
3 6000000 0.751 4507888.81
4 6750000 0.683 4610340.82
5 7000000 0.621 4346449.26
6 7200000 0.564 4064212.30
26619800.2778341
Initial investment 16000000
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NPV 10619800.2778341
Payback-period
Year Cash flows Cumulative cash flow
0 16000000
1 5000000 5000000
2 5500000 10500000
3 6000000 16500000
4 6750000 23250000
5 7000000 30250000
6 7200000 37450000
Total cash flows 37450000
Initial investment 16000000
0.4272363151
IRR
Year Cash flows
0 -16000000
1 5000000
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2 5500000
3 6000000
4 6750000
5 7000000
6 7200000
IRR 28.83%
3. Recommendation to select investment venture
Investment appraisal techniques are quite essential in business so that it may be able to
select effective project and invest in the same. RCL Ltd had two options for expansion such as
Reading Venture and Bristol one. For assessing attractiveness of project, NPV, IRR and payback
period are computed. It can be interpreted that NPV of Reading Venture is 37665409.38 and of
another venture is 10619800.27. It is clarified that first option has better NPV and as such, it
should be selected by RCL Ltd as it yields adequate returns.
On the other hand, payback period is computed which states that Reading Venture has
less period in comparison to Bristol Venture. This implies that project of first option will provide
results within stipulated time and it should be selected by organisation (Chircop, Johan and
Tarsalewska, 2017). Apart from this, IRR shows that Bristol Venture has 28.83 % and other
option has 40.85 % of IRR. It can be analysed that Reading Venture investment is quite effective
as it yields more return in terms of IRR. Thus, it is recommended to RCL Ltd that it should
invest money in this project as it is useful in terms of profitability.
CONCLUSION
Hereby it can be concluded that capital budgeting plays crucial role in the organisation
and management is benefited to take effective decisions with much ease. Moreover, capital
investment techniques or methods such as NPV, Payback period and IRR are quite useful to
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