Capital Budgeting Project Analysis

This assignment presents a detailed analysis of a capital budgeting project. It involves calculating the Net Present Value (NPV) and the Discounted Payback Period to evaluate the project's profitability. The analysis includes present values of net cash flows, calculated over several years. The conclusion, based on quantitative factors, recommends accepting the project.

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FINANCIAL MANAGEMENT

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CONTENT
1. INTRODUCTION 3
2. QUALITATIVE FACTORS 4-6
3. QUANTITATIVE FACTORS 7
4. RECOMMENDATION AND JUSTIFICATION 8-9
6. CONCLUSION 10

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INTRODUCTION
A company has to take various decisions in its day to day operation. These decisions must be taken correctly and promptly so that there is a
positive impact on the company. In order to take such decisions there is a common tool used by various companies known as capital budgeting.
Using this tool the company is able to take certain important decisions relating to the capital investment of the company. As there is a huge
capital involved in the project it is necessary to first analyse its impact.
We have been provided with the case study of Leadall, in which we are required to evaluate the opportunity of making FP17. We need to analyse
whether the company will have enough profits or not (Dayananda, 2008). The net present value and discounted payback period will help us to
take decision better.

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QUANTITATIVE FACTORS
EVALUATING THE NET PRESENT VALUE OF THE PROJECT.
Capital budgeting involves various methods and techniques, one of which is net present value (Wilkes, n.d.). Net present value is very
commonly used by all the companies to take decisions.Net present values are calculated based on the future cash inflows of the company, these
cash flows are not actual but are estimated. The estimations of the cash flow involve various assumptions and also there are certain other factors
that are taken into consideration. The total cash flow is then calculated at the end of the year for a particular project. These cash flows are
discounted with the help of cost of capital. It is considered favourable when the positive discounted cash flows exceed the negative discounted
cash flows. Whereas if the opposite happens then the project should not be accepted as it is not considered to be viable (Bedi, n.d.).
Calculation showing net present value:
Particulars 0 1 2 3 4 5
Initial Investment
- Cost of Machinery -70,00,000 - - - - 9,00,000
- Working Capital Requirements -5,00,000 5,00,000
Operating transactions
Sale 80,00,000 72,00,000 64,00,000 56,00,000 48,00,000
Variable Cost -40,00,000 -36,00,000 -32,00,000 -28,00,000 -24,00,000
Fixed Factory Overhead -1,50,000 -1,50,000 -1,50,000 -1,50,000 -1,50,000
Depreciation -10,50,000 -10,50,000 -10,50,000 -10,50,000 -10,50,000
Opportunity Cost -15,000 -15,000 -15,000 -15,000 -15,000
Loss on Sale of Machinery - - - - -8,50,000
Net Income before tax 27,85,000 23,85,000 19,85,000 15,85,000 3,35,000
Less : Income Tax @30% 8,35,500 7,15,500 5,95,500 4,75,500 1,00,500
Profit after tax 19,49,500 16,69,500 13,89,500 11,09,500 2,34,500
Add: Non cash expenses 10,50,000 10,50,000 10,50,000 10,50,000 19,00,000
Operating Cash flow before tax 38,35,000 34,35,000 30,35,000 26,35,000 22,35,000

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Total Cash Flows from the project -75,00,000 38,35,000 34,35,000 30,35,000 26,35,000 36,35,000
PV Factor @ 20% 1.000000 0.833333 0.694444 0.578704 0.482253 0.401878
Present Values of Net cash flows -75,00,000 31,95,833 23,85,417 17,56,366 12,70,737 14,60,825
NPV 25,69,178
Notes:
- The expenditure of $150000 has been ignored while taking the decision as it is a sunk cost.
- The import duty has been included in the cost of machinery.
- It is assumed that the working capital of the company will be recovered at the completion of this particular project.
-The opportunity cost that has been lost has also been taken into consideration while taking the decision.
- Normal rates has been charged for capital gain.
Calculation of Capital Gain/Loss
Book Value at the end of 5th year 17,50,000
Less: Salvage 9,00,000
Capital Loss 8,50,000

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EVALUATING THE PAY-BACK PERIOD OF THE PROJECT
Apart from NPV, the other commonly used method of capital budgeting is the payback period method. The simple way to define the payback
period is the time taken by the company to recover the investments made by it. The payback period can be classified into two groups- firstly
general pay back and secondly discounted pay back period. In case of general payback period, the cash flows of general nature are taken into
consideration whereas in case of discounted payback period only discounted cash flows are taken (Jacobs, 2008).
The case study of Leadall corp demands a payback period of 4 years. On observing the table that reflects the discounted cash flows we can see
that the investments made by the company are being recovered in 4 years. Hence, we can conclude that the company’s demand of a specified
payback period is fulfilled. We can also conclude that the project should be accepted by the company (Herbst, n.d.).
Discounted Payback Period
Yea
r Cash flows Cumulative Cash flows
- -75,00,000 -75,00,000
1 31,95,833 -43,04,167
2 23,85,417 -19,18,750
3 17,56,366 -1,62,384
4 12,70,737 11,08,353
5 14,60,825 25,69,178

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QUALITATIVE FACTORS
ACCEPTANCE OR REJECTANCE OF ORDER
According to the net present value and discounted payback period the company should accept the order. The working of the net present value
clearly shows that there is a positive net present value and the payback period requirement is also satisfied (Capital Budgeting Valuation, 2013).
On checking these two we can say that on the basis of quantitative factors the project should be accepted but there are also certain qualitative
factors that should be kept in mind. They are-
1. Funds availability- Huge funds are required by the company to carry out capital budgeting projects. However, if the funds are short there
may be a failure in the execution process of the project. Therefore, sufficient funds should be available to carry out such investments.
2. Requirement of working capital- It is important for the company to maintain proper funds to meet its short term expenses, any shortage in
the working capital of the company may cause difficulty in carrying out operations (Dayananda, 2008).
3. Government rules and regulations- The company before accepting the order should have a detailed knowledge about the policies of the
government that may be related to such projects. As we know, it is not possible to carry out any business without any legal compliance.
4. Return on capital- The expected returns from these kind of projects are higher compared to the other projects. As we know, that market
as well as economy is dynamic in nature there is no certainty of the amount of revenue that could be generated from a particular project.
5. Use of assumptions- The technique of capital budgeting uses many kind of assumptions in order to arrive at the conclusion. It is kind of
impossible to draw a conclusion without making these assumptions. However, there should be appropriate evidences available for taking
these assumptions. If there is no logical reasoning for taking such assumption then the company may take wrong decisions.
6. Issues involved in calculating cost of capital- If the company calculates a wrong cost of capital and takes a decision based on it then there
is a chance that it will be inaccurate. The company should first evaluate that the existing capital structure is appropriate or not for the
concerned project. There may be a need of the new cost of capital of the project. Although the calculation of cost of capital is a lengthy
process as well as very complex but it is very important also.

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JUSTIFICATION AND RECOMMENDATION
EVALUATING THE EXPENSES ON RESEARCH AND DEVELOPMENT
The company has incurred certain cost on Research and development, and so the managing director of the company wants to evaluate the
impact of this cost in the performance of the company. Currently, the company is incurring 3% of its total revenue as a research and
development expenditure (Clark, Hindelang and Pritchard, n.d.).
However, there is an impact on the net present value significantly when the company is incurring 3% of revenue on research and
development. It is observed that the net present value for the project falls down from $2569178 to $2509178 which is not considered to be
good. However, it does not affect the payback period as it continues to remain 4 years approximately. Although there is a fall in the net
present value but it has still continued to be positive therefore, the company should still accept the order.
Hence, we can conclude that the company can contribute towards the research and development if it wants to as the NPV is not becoming
negative. (Shapiro, n.d.)
The profits that could be earned are shown below:
Particulars 0 1 2 3 4 5
Initial Investment
- Cost of Machinery -70,00,000 - - - - 9,00,000
- Working Capital Requirements -5,00,000 5,00,000
Operating transactions
Sale 80,00,000 72,00,000 64,00,000 56,00,000 48,00,000
Variable Cost -40,00,000 -36,00,000 -32,00,000 -28,00,000 -24,00,000
Fixed Factory Overhead -1,50,000 -1,50,000 -1,50,000 -1,50,000 -1,50,000
Depreciation -10,50,000 -10,50,000 -10,50,000 -10,50,000 -10,50,000
Opportunity Cost -15,000 -15,000 -15,000 -15,000 -15,000
R & D Expense -24,000 -21,600 -19,200 -16,800 -14,400
Loss on Sale of Machinery - - - - -8,50,000

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Net Income before tax 27,61,000 23,63,400 19,65,800 15,68,200 3,20,600
Less : Income Tax @30% 8,28,300 7,09,020 5,89,740 4,70,460 96,180
Profit after tax 19,32,700 16,54,380 13,76,060 10,97,740 2,24,420
Add: Non cash expenses 10,50,000 10,50,000 10,50,000 10,50,000 19,00,000
Operating Cash flow before tax 38,11,000 34,13,400 30,15,800 26,18,200 22,20,600
Total Cash Flows from the project -75,00,000 38,11,000 34,13,400 30,15,800 26,18,200 36,20,600
PV Factor @ 20% 1.000000 0.833333 0.694444 0.578704 0.482253 0.401878
Present Values of Net cash flows -75,00,000 31,75,833 23,70,417 17,45,255 12,62,635 14,55,038
NPV 25,09,178
Discounted Payback Period
Yea
r Cash flows Cumulative Cash flows
- -75,00,000 -75,00,000
1 31,75,833 -43,24,167
2 23,70,417 -19,53,750
3 17,45,255 -2,08,495
4 12,62,635 10,54,140
5 14,55,038 25,09,178

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CONCLUSION
Capital budgeting technique is widely used by many companies as it has proved itself to be useful for decision making. We could help in
evaluating and analysing the outcome of the acceptance of this project only because of its application. After a detailed study, now we could
conclude that the company should accept the project on the basis of quantitative factors (Goel, 2015).

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REFERENCES:
Bedi, A. (n.d.). Capital budgeting. New Delhi: Deep & Deep Publications.
Capital Budgeting Valuation. (2013). Hoboken, N.J.: Wiley.
Clark, J., Hindelang, T. and Pritchard, R. (n.d.). Capital budgeting. Englewood Cliffs, N.J.: Prentice-Hall.
Dayananda, D. (2008). Capital budgeting. New York: Cambridge University Press.
Goel, S. (2015). Capital Budgeting. Business Expert Press.
Herbst, A. (n.d.). Capital budgeting. Cambridge, Angleterre: Harper & Row.
Jacobs, D. (2008). A review of capital budgeting practices. Washington, D.C.: International Monetary Fund, Fiscal Affairs Dept.
Peterson, P. and Fabozzi, F. (n.d.). Capital budgeting. New York: Wiley & Sons.
Shapiro, A. (n.d.). Capital budgeting and investment analysis. Upper Saddle River, NJ: Pearson/Prentice Hall.
Wilkes, F. (n.d.). Capital budgeting techniques. Chichester: John Wiley & Sons.