Capital Budgeting Analysis: Evaluating Project Proposals and Risks

This assignment presents a comprehensive capital budgeting analysis of a project under three different scenarios: base, worst, and best case. The analysis includes the creation of income statements, cash flow projections, and the calculation of key financial metrics such as Net Present Value (NPV), Profitability Index (PI), Payback Period, and Discounted Payback Period. The project evaluates the financial viability of the project using discounted cash flow analysis and considers the cost of capital and tax rates. The solution also discusses the acceptance or rejection of the project based on the capital budgeting rules, and the importance of considering probability weights for each scenario to make an informed decision. Furthermore, the assignment explores alternative capital budgeting approaches to manage project risk, including the use of risk-adjusted discount rates, probabilities, decision trees, managerial real options, standard deviation, and coefficient of variation.

Part A Solutions
1. Base Case
Assumptions
Cost 1,650,000
n-years 8
Cost of capital 16%
tax rate 30%
Resale value 100,000
Revenues 10.00%
Cost 6.00%
Income statement
Revenue 1,445,000 1,589,500 1,748,450 1,923,295 2,115,625 2,327,187 2,559,906 2,815,896
Cost of Goods - - - - - - - -
Gross Profit 1,445,000 1,589,500 1,748,450 1,923,295 2,115,625 2,327,187 2,559,906 2,815,896
operating costs 1,181,000 1,251,860 1,326,972 1,406,590 1,490,985 1,580,444 1,675,271 1,775,787
EBITDA 264,000 337,640 421,478 516,705 624,639 746,743 884,635 1,040,109
Depreciation Exp 206,250 206,250 206,250 206,250 206,250 206,250 206,250 206,250
EBIT 57,750 131,390 215,228 310,455 418,389 540,493 678,385 833,859
Interest Exp 0 0 0 0 0 0 0 0
EBT 57,750 131,390 215,228 310,455 418,389 540,493 678,385 833,859
Tax 17,325 39,417 64,569 93,137 125,517 162,148 203,515 250,158

Net Income 40,425 91,973 150,660 217,319 292,872 378,345 474,869 583,701
Periods 0 1 2 3 4 5 6 7 8
Cash Flow –In 0 1,445,000 1,589,500 1,748,450 1,923,295 2,115,625 2,327,187 2,559,906 2,815,896
Cash Flow -Out investing 1,650,000 (70,000)
Cash Flow -Out operating 1,198,325 1,291,277 1,391,540 1,499,726 1,616,502 1,742,592 1,878,786 2,025,945
a)After Tax Net Cash
Flow (1,650,000) 246,675 298,223 356,910 423,569 499,122 584,595 681,119 859,951
Cumulative CF (1,650,000) 246,675 544,898 901,808 1,325,376 1,824,499 2,409,094 3,090,213 3,950,164
b) Pay Back period 4.650
Discounted CF (1,650,000) 212,651 221,628 228,657 233,933 237,639 239,942 241,000 262,307
Cumulative DCF (1,650,000) 212,651 434,279 662,936 896,869 1,134,508 1,374,450 1,615,451 1,877,758
c) Discounted PBP 7.132
d) NPV $ 227,758
e) Profitability Index 1.13803

2. Worst case
Assumptions
Cost 1,650,000
n-years 8
Cost of capital 16%
tax rate 30%
Resale value 100,000
Revenues 6.00%
Cost 10.00%
Income statement
Revenue 1,445,000 1,531,700 1,623,602 1,721,018 1,824,279 1,933,736 2,049,760 2,172,746
Cost of Goods - - - - - - - -
Gross Profit 1,445,000 1,531,700 1,623,602 1,721,018 1,824,279 1,933,736 2,049,760 2,172,746
operating costs 1,181,000 1,299,100 1,429,010 1,571,911 1,729,102 1,902,012 2,092,214 2,301,435
EBITDA 264,000 232,600 194,592 149,107 95,177 31,724 (42,453) (128,689)
Depreciation Exp 206,250 206,250 206,250 206,250 206,250 206,250 206,250 206,250
EBIT 57,750 26,350 (11,658) (57,143) (111,073) (174,526) (248,703) (334,939)
Interest Exp 0 0 0 0 0 0 0 0
EBT 57,750 26,350 (11,658) (57,143) (111,073) (174,526) (248,703) (334,939)
Tax 17,325 7,905 (3,497) (17,143) (33,322) (52,358) (74,611) (100,482)

Net Income 40,425 18,445 (8,161) (40,000) (77,751) (122,168) (174,092) (234,457)
Periods 0 1 2 3 4 5 6 7 8
Cash Flow -In Revenue 0 1,445,000 1,531,700 1,623,602 1,721,018 1,824,279 1,933,736 2,049,760 2,172,746
Cash Flow -Out investing 1,650,000 (70,000)
Cash Flow -Out operating 1,198,325 1,307,005 1,425,513 1,554,768 1,695,780 1,849,654 2,017,603 2,200,953
After Tax Net Cash
Flow (1,650,000) 246,675 224,695 198,089 166,250 128,499 84,082 32,158 41,793
Cumulative CF (1,650,000) 246,675 471,370 669,459 835,709 964,208 1,048,290 1,080,448 1,122,240
Pay Back period >8
Discounted CF (1,650,000)
$
212,651
$
166,985
$
126,907
$
91,818
$
61,180
$
34,511
$
11,378
$
12,748
Cumulative DCF (1,650,000) 212,651 379,636 506,543 598,362 659,542 694,052 705,431 718,178
Discounted PBP >8
NPV (931,822)
Profitability Index 0.43526

3. Best case
Assumptions
Cost 1,650,000
Salvage
n-years 8
Cost of capital 16%
tax rate 30%
Resale value 100,000
Revenues 15.00%
Cost 3.00%
Income statement
Revenue 1,445,000 1,661,750 1,911,013 2,197,664 2,527,314 2,906,411 3,342,373 3,843,729
Cost of Goods - - - - - - - -
Gross Profit 1,445,000 1,661,750 1,911,013 2,197,664 2,527,314 2,906,411 3,342,373 3,843,729
operating costs 1,181,000 1,216,430 1,252,923 1,290,511 1,329,226 1,369,103 1,410,176 1,452,481
EBITDA 264,000 445,320 658,090 907,154 1,198,088 1,537,308 1,932,197 2,391,248
Depreciation Exp 206,250 206,250 206,250 206,250 206,250 206,250 206,250 206,250
EBIT 57,750 239,070 451,840 700,904 991,838 1,331,058 1,725,947 2,184,998
Interest Exp 0 0 0 0 0 0 0 0
EBT 57,750 239,070 451,840 700,904 991,838 1,331,058 1,725,947 2,184,998
Tax 17,325 71,721 135,552 210,271 297,551 399,318 517,784 655,499
Net Income 40,425 167,349 316,288 490,633 694,287 931,741 1,208,163 1,529,498
Periods 0 1 2 3 4 5 6 7 8
Cash Flow –In 0 1,445,000 1,661,750 1,911,013 2,197,664 2,527,314 2,906,411 3,342,373 3,843,729
Cash Flow -Out investing 1,650,000 (70,000)
Cash Flow -Out operating 1,198,325 1,288,151 1,388,475 1,500,782 1,626,777 1,768,420 1,927,960 2,107,980

After Tax Net Cash
Flow (1,650,000) 246,675 373,599 522,538 696,883 900,537 1,137,991 1,414,413 1,805,748
Cumulative CF (1,650,000) 246,675 620,274 1,142,812 1,839,694 2,740,231 3,878,222 5,292,635 7,098,383
Pay Back period 3.728
Discounted CF (1,650,000)
$
212,651
$
277,645
$
334,768
$
384,882
$
428,757
$
467,080
$
500,461
$
550,799
Cumulative Discounted
CF (1,650,000) 212,651 490,296 825,064 1,209,946 1,638,703 2,105,782 2,606,244 3,157,043
Discounted PBP 5.024
NPV 1,507,043
Profitability Index 1.91336

Discuss other capital budgeting approaches to allow for riskiness
To handle the increased riskiness in capital budgeting, other approaches other than
sensitivity analysis, that may be used to assess the project include:-
 Using a risk adjusted discount rate which will include a risk premium dependant on
the degree of risk.
 Use of probabilities to assess the likelihood of events.
 Use of decision trees to assess probabilistic estimates of potential outcomes.
 Use of managerial real options
 Use of standard deviation and coefficient of variation to assess the measure of
dispersion
Discuss whether proposal should be accepted and any further information
required to help make the accept/reject decision
According to the capital budgeting rules, if we review each of the three scenarios we get
the following:
Base case-The proposal should be accepted for following reasons
 NPV >0
 Profitability index >1
 Payback period and Discounted Pay back period is less than the lifetime of
project implying they will break even before completion of project.
Worst Case-The proposal should be rejected for following reasons
 NPV <0
 Profitability index <1
 Payback period and Discounted Pay back period is greater than the lifetime of
project.
Best Case-The proposal should be accepted for following reasons
 NPV >0
 Profitability index >1
 Payback period and Discounted Pay back period is less than the lifetime of
project.
From above we are not able to make an informed decision as each of the three
scenarios provides different rules. We will therefore at least require the probability
weights for the base, best and worst scenarios. This will assist us to determine their
respective weights and thus make an informed decision.