Application in Capital Budgeting

This document discusses the application of capital budgeting in finance and its impact on decision making. It covers relevant assumptions, treatment of depreciation, treatment of working capital, calculation of initial capital outlay, and calculation of NPV. The conclusion highlights the net present value and internal rate of return, indicating the acceptability of the proposal.

Running head: FINANCE 1
Application in Capital Budgeting

FINANCE 2
Table of Contents
TASK 2a..........................................................................................................................................3
Relevant Assumptions.....................................................................................................................3
Treatment of depreciation................................................................................................................3
Treatment of Working Capital.........................................................................................................4
Calculation of initial capital outlay..................................................................................................4
Calculation of NPV..........................................................................................................................4
Conclusion.......................................................................................................................................5
Task 2B............................................................................................................................................5
References........................................................................................................................................6

FINANCE 3
TASK 2a
Relevant Assumptions
There are certain assumptions which have been undertaken to arrive at the calculations and
help the company to take the decisions.
1. The costs such as the developmental costs, testing costs and initial marketing costs are
included in the initial capital outlay as the company is forming the drug, and these
expenses accounts for the major expenses that require for the formation of each and every
drug
2. The next assumption is that depreciation is added back (Hopkinson, 2017).
3. The treatment of working capital is shown in the yearly cash flows.
Treatment of depreciation
The depreciation is added back to the profits to arrive at the annual cash flows. This is the
case as depreciation is a non-cash expense and yet it is accounted for the purpose of the tax.
Since the amount affects the amount of the taxes therefore it is first deducted from the profits and
at last added back to the profits to arrive at the annual cash flows. For the table below it can be
analyzed that the depreciation amount is less as compared to the situation where the depreciation
is not charged (Johnson & Pfeiffer, 2016).
With Depreciation Without Depreciation
EBIDTA 10900000 10900000
Depreciation 780000 0
PBT 10120000 10900000
Tax @ 30% 3036000 327000
PAT 7084000 7630000

FINANCE 4
Treatment of Working Capital
While taking the decisions in the capital budget the treatment of the working capital deals
with the accounts receivable and accounts payable. Cash flow increase when the accounts
receivable decrease or in the reverse situation the accounts payable increase and vice versa
(Abor, 2017).
Calculation of initial capital outlay
Calculation of capital
outlay Amount ($) Amount ($)
Developing strategy 20000000
Marketing Study 12000000
Testing costs 10000000 42000000
Add: Cost of Equipment 8000000
Total Initial cash outlay 50000000
Calculation of NPV
Net Present value Rate of
Return
@11.5%
Net
Present
value
0 -50000000 1.0000 -50000000
1 7864000 0.8969 7052915
2 8872000 0.8044 7136279
3 9980800 0.7214 7200137
4 11200480 0.6470 7246648
5 31325200 0.5803 18176887
6 31325200 0.5204 16302141
7 31325200 0.4667 14620754
8 31325200 0.4186 13112784
9 31325200 0.3754 11760345
10 31325200 0.3367 10547394
Net Present Value 63156284

FINANCE 5
Conclusion
The net present value of the proposal is $63156284 and the internal rate of return is 29%
is respect to the cost of capital at 11.5%. This suggests that the net present value is positive and
the IRR is sound. The company can accept the proposal as the present value tends to be of more
value and the positive value indicates that the project is going to deliver the returns. The higher
the internal rate of return the more are the chances of the acceptance of the proposal, hence on
the basis of the analyses it can be concluded that the proposal is acceptable (Leyman &
Vanhoucke, 2017).
Task 2B
Refer to the excel file

FINANCE 6
References
Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital
Hopkinson, M. (2017). Net Present value and risk modelling for projects. Routledge.
Johnson, N. B., & Pfeiffer, T. (2016). Capital budgeting and divisional performance
measurement. Foundations and Trends® in Accounting, 10(1), 1-100.
Leyman, P., & Vanhoucke, M. (2017). Capital-and resource-constrained project scheduling with
net present value optimization. European Journal of Operational Research, 256(3), 757-
776.