Capital Budgeting for Phone Manufacturing

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This assignment examines the application of capital budgeting techniques to a scenario involving a phone manufacturing company considering two investment options (Option A and Option B). It requires students to calculate Net Present Value (NPV) and Internal Rate of Return (IRR) for each option using provided data. The analysis should also include sensitivity analysis to assess the impact of changes in sales price, sales volume, and raw material costs on project profitability. Finally, the assignment explores operating lease advantages and disadvantages in the context of this scenario.

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FINANCE

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EXECUTIVE SUMMARY
Financial planning and evaluation is highly significant which in turn provides high level
of assistance to the manager in making selection of best option out of several alternatives.
Moreover, at the time of availability of several options manager faces difficulty in making
selection of the best project that aid in the growth and success of firm. In this regard, financial
tools and techniques such as investment appraisal provide high level of assistance in evaluating
the viability of proposals. Capital budgeting tools clearly state the return and time period within
which firm will recover its initial investment. For this project report, scenario of Phone company
has been considered which is involved in the activities of manufacturing covers. It can be
summarized from the report that business unit should go with the proposal A which in turn offers
higher return to the company. Moreover, in the case of project B, NPV and IRR accounts for
significantly. It can be seen in the report that WACC is 17% which in turn considered as
discounting factor. Along with this, it can be stated that by developing strategic and competent
framework on the basis of sensitivity analysis business unit can gain competitive edge over
others. FG
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TABLE OF CONTENTS
EXECUTIVE SUMMARY.............................................................................................................2
INTRODUCTION...........................................................................................................................1
a. Computation of WACC to determine required rate of return..................................................1
(b) Preparation of cash flows and inclusion or exclusion of items..............................................1
© Viability of alternative.............................................................................................................3
(d) Uneual lives of the project and its impact on recommendation.............................................4
e.Sensitivity analysis....................................................................................................................4
f. Sensitivity analysis of sale unit, revenue and raw material cost..............................................5
(g) Advantage and disadvantage of lease....................................................................................6
CONCLUSION................................................................................................................................6
REFERENCES................................................................................................................................8
Table 1Calcualtion of NPV.............................................................................................................3
Table 2Calculation of IRR...............................................................................................................3
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INTRODUCTION
In the present times, business entities can attain success only when it develops highly
competent plan or framework. Now, several financial options are available to the firm which
they it can use for the maximization of productivity and profitability. In this regard, finance
manager of the firm can take suitable decision by using monetary tools and techniques. This in
turn helps business unit in making optimum use of financial resources and thereby assists in
getting the desired level of outcome or success. The present report is based on the case scenario
on phone which is a leading manufacturing company in Perth CBD. It manufactures and offers
quality iPhone covers to the customers which are made from elastomer. In this, report will shed
light on the manner in which investment appraisal tool and techniques aid in decision making.
Besides this, report will also highlight the proposal which company should select out of two
available options. Further, it also depicts the \extent to which unequal lives of the project has
influence on the selection of proposal.
a. Computation of WACC to determine required rate of return
WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]
Particulars Figures
Market value of the company's equity (E) $8 million
Market value of the company's debt (D) $2 million
Total Market Value of the company (V = E + D) 10 million
cost of equity (Re) 14%
Cost of debt (Rd) 9%
Tax rate 30%
WACC 17%
The above depicted table clearly shows that WACC is 17% which in turn considered by
an analyst as discounting factor. By taking into account such discounting factor financial analyst
of Phone will assess whether the company should purchase new machinery or make focus
proposal
(b) Preparation of cash flows and inclusion or exclusion of items
Year
1
Year
2
Year
3
Year
4
Year
5
Year
6
Year
7
Year
8
Year
9
Sales revenue
15750
00
17325
00
19057
50
20963
25
2305
958
25365
53
27902
09
30692
29
33761
52
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Other income 0 0 0 0 0 0 0 0 0
Total income
15750
00
17325
00
19057
50
20963
25
2305
958
25365
53
27902
09
30692
29
33761
52
Expenditure
Raw material
cost
12500
0
12750
0
13005
0
13265
1
1353
04
13801
0.1
14077
0.3
14358
5.7
14645
7.4
Capital
expenditure 80000 0 0 0
1000
00 0 0 0 0
Variable cost
85950
0
85950
0
85950
0
85950
0
8595
00
85950
0
85950
0
85950
0
85950
0
Advertisement
expenses 30000 30000 30000 30000
3000
0 30000 30000 30000 30000
Depreciation
92777
.78
92777
.78
92777
.78
92777
.78
1059
444
10594
44
10594
44
10594
44
10594
44
Interest
18000
0
18000
0
18000
0
18000
0
1800
00
18000
0
18000
0
18000
0
18000
0
Fixed cost
15000
0
15000
0
15000
0
15000
0
1500
00
15000
0
15000
0
15000
0
15000
0
Total
15172
78
14397
78
14423
28
14449
29
2514
248
24169
55
24197
15
24225
30
24254
02
Pretax cash
inflow
57722
.22
29272
2.2
46342
2.2
65139
6.2
-
2082
91
11959
8.7
37049
3.8
64669
9.3
95075
0.5
Tax rate 30%
17316
.67
87816
.67
13902
6.7
19541
8.9
-
6248
7.3
35879
.61
11114
8.1
19400
9.8
28522
5.2
After tax cash
inflow
40405
.56
20490
5.6
32439
5.6
45597
7.4
-
1458
04
83719
.09
25934
5.7
45268
9.5
66552
5.4
Interest expenses on 2 million loan can be included in the calculation because loan is taken in
respect to current business project. Due to this reason interest expenses must be included in the
calculation. In the table given above it can be observed that interest amount is included that is
charged on 2million. Amount of 80000 that is spend to rehabilitate plant is another option on
which there is need to pay due attention in the cash flow projection. Mentioend expenditure will
be included in the project because plant on which work is done is currnetly used in the project as
machines will be installed in same project. Hence, expenditure made on plant is indirectly linked
to the current project and due to this reason it must be included in the project expected cash
flows. Associated production costs and reduction in existing sales must also be included in the
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project. This is because production will be done by using machine and due to this reason in this
way production cost is associated with the current project cash inflows.
© Viability of alternative
Table 1Calcualtion of NPV
Project
A
Pv
@9%
Presen
t value Project B
PV
@9%
Present
value
Initial investment
107500
0 470000
1
40405.5
6 0.917 37069 40405.56
0.91743
1
37069.3
2
2
204905.
6 0.842
17246
5 204905.6 0.84168
172464.
9
3
324395.
6 0.772
25049
3 324395.6
0.77218
3
250492.
9
4
455977.
4 0.708
32302
6 455977.4
0.70842
5
323025.
9
5 -145804 0.650
-
94762
6
83719.0
9 0.596 49919
7
259345.
7 0.547
14187
1
8
452689.
5 0.502
22719
0
9
665525.
4 0.460
30642
6
Total
73821
0 783053
NPV
-
33679
0 313053
Table 2Calculation of IRR
Project
A Project B
Initial investment - -470000
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1075000
1 40405.56 40405.56
2 204905.6 204905.6
3 324395.6 324395.6
4 455977.4 455977.4
5 -145804
6 83719.09
7 259345.7
8 452689.5
9 665525.4
IRR 14.74% 29.02%
Interpretation
NPV: NPV reflect net present value that remain in the proeject after subtracting cash outflow
amount from inflow amount (Burke, 2013). It can be observed from the tables govem above that
NPV of project A is -33670 and same for project B is 31053. On this basis it can be said that
Project B seems viable for the business firm.
IRR: It is another important tool which reflect real rate of return that can be earned on the project
(Blengini and et.al., 2012). It can be observed from the table given above that IRR of project A is
14.74% and same for project B is 29.02%. On this basis it can be said that Project B is viable for
the business firm because highehr amount of return is earned on mentioned project.
(d) Uneual lives of the project and its impact on recommendation
Unequal lives of the project will not change recommendation because it can be observed
that one project life is 9 years but other project life is 4 years and cash flows for both projects are
same. Expenses are kept constant and only raw material expenses as well as revenue are
increased by considering specific growth rate. Machine cost and lives are different but cash
flows are expected to be same for both due to same production capacity of both. However, in
case of first machibe maintinance expenses are high as capital expenditure required and due to
this reason less cash flows are earned in option A but same thing is not in case of option B.
Hence, due to this reason lives of project or options does not lead to change in recoemndation.
e.Sensitivity analysis
On the basis of the outcome of sensitivity analysis, it is advised to the management team
of Phone that emphasis needs to be placed on two variables such as sales unit and the cost of raw
material. Moreover, sales units will decline from 450000 units to 292500 if percentage of falling
accounts for 35%. Hence, reduction in such units will place direct impact on revenue and thereby
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profit margin of firm. Along with this, business unit is required to exert control on material cost
by assessing the best supplier. Besides this, by undertaking the technique of budgetary control
business entity of mobile manufacturing company can control the level of expenses and thereby
would become able to generate high profit (Tsai and et.al., 2011).
f. Sensitivity analysis of sale unit, revenue and raw material cost
On the basis of given case situation, different rates have been considered by the analysts
to determine the extent to which sales unit and price will fall in the near future. Besides this, to
determine the extent to which material cost will incline rate of 35% has been considered.
Sales volume
Condition Outcome
optimistic 450000 + (450,000 * 35%) = 607500 units
Pessimistic. 450000 - (450,000 * 35%) = 292500 units
Sales price
Condition Outcome
Optimistic $3.50 + (3.50 * 20%) = $4.2
Pessimistic. $3.50 - (3.50 * 20%) = $2.8
Raw Material cost
Condition Outcome
Optimistic $125000 + (125000 * 30%) = $162500
Pessimistic. $125000 - (125000 * 30%) = $87500
Decline in sales price and sales volume and raw material cost will not have impact on
recommendation and option B will be prefeered choice. However, if on application of declined
values of sales volume and price if it is identified that NPV of option B is negative and IRR is
very low then in that case none of option will be selected for the firm.
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(g) Advantage and disadvantage of lease
From assessment, it has been identified that in the case of option B, phone manufacturing
company should lay emphasis on adopting the system of operating lease. On the basis of such
aspect or lease arrangement, firm would become able to use an asset by making payment of rent.
However, such lease does not convey the right of ownership pertaining to asset. Such lease
arrangement has following advantages and drawbacks which business unit needs to keep in mind
while taking decision in relation to the same:
Advantages of operating lease
Operating lease arrangement is highly effectual which in turn provides high level of
assistance in reducing the level of business risk to a great extent. Hence, by undertaking
such lease for short-term Phone company would become able to get monetary benefits.
Moreover, in the case of operating lease, responsibility pertaining to maintenance will be
carried out by lessor.
Further, in operating lease, business entity will not carry the risk in relation to decline in
the value of assets due to damages
(The pros and cons of an operating lease, 2017).
Disadvantages of operating lease
In this, business entity is accountable in relation to making use of assets as per the terms
and conditions mentioned in the contract.
Under operating lease, lessee would not become able to take benefits in relation to the
increase in value of assets etc.
Hence, such lease arrangement will not place high level of emphasis on WACC because
operating lease arrangement is considered as off-balance sheet transaction. However, rent on
assets will reduce the level of expenses and thereby enhances cash flow significantly.
CONCLUSION
On the basis of above discussion it is concluded that there is significent importance of
capital budgeting methods because by using same best option can be selected by the firm.
However, there are number of factors that need to be consider while estimating cash flows of
project. Sensitivity analysis must also be conducted while making any decision because by using
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same it can be identified that in case if any unfortunate event takes place then whether project
will be viable or firm will need to stop work on project in middle.
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REFERENCES
Books and Journals
Burke, R., 2013. Project management: planning and control techniques. New Jersey. USA.
Blengini, G.A. and et.al., 2012. Life Cycle Assessment guidelines for the sustainable production
and recycling of aggregates: the Sustainable Aggregates Resource Management project
(SARMa). Journal of Cleaner Production. 27. pp.177-181.
Tsai, W.H. and et.al., 2011. Incorporating life cycle assessments into building project decision-
making: an energy consumption and CO 2 emission perspective. Energy. 36(5). pp.3022-
3029.
Online
The pros and cons of an operating lease. 2017. [Online]. Available through: <
http://fspbusiness.co.za/articles/accounting/revealed-the-pros-and-cons-of-a-finance-lease-
and-an-operating-lease-2753.html>. [Accessed on 3rd November 2017].
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