Capital Budgeting: FP17 Project Financial Analysis and Evaluation

This report provides a comprehensive analysis of the FP17 project for Leadall Corp, focusing on capital budgeting techniques. It begins with an executive summary and introduction to capital budgeting, emphasizing its role in organizational decision-making. The findings section presents both quantitative and qualitative analyses. The quantitative analysis includes detailed calculations of the project's Net Present Value (NPV) and discounted payback period, demonstrating the financial viability of the project. The qualitative analysis considers factors such as fund availability, working capital requirements, economic volatility, government policies, and the importance of accurate assumptions in capital budgeting. The recommendation section concludes that the project should be accepted based on the positive NPV and the satisfaction of the management's payback period requirement. The report also assesses the impact of allocating a portion of sales revenue to Research & Development, showing that the project remains viable. The report concludes by summarizing the key findings and reinforcing the utility of capital budgeting for sound financial decision-making. The report includes calculations and references to support its findings.

Financial Management
1

Executive Summary
The following assignment contains a study on capital budgeting. It involves a case study and application of the concept of capital budgeting in
the given situation. We would see how capital budgeting helps us in decision making by considering both the qualitative and quantitative factors.
2

Contents
Executive Summary....................................................................................................................................................................................................................... 2
Introduction................................................................................................................................................................................................................................... 5
Findings......................................................................................................................................................................................................................................... 6
Quantitative............................................................................................................................................................................................................................... 6
Qualitative............................................................................................................................................................................................................................... 10
Recommendation and Justification.............................................................................................................................................................................................. 12
Conclusion................................................................................................................................................................................................................................... 15
References............................................................................................................................................................................................................................... 16
3

4

Introduction
Decision making is one of the most vital parts of growth of an organisation. In order to ensure sustainability and growth it is necessary for the
management to take correct decisions. Capital budgeting is the one of the most common and simple tools of decision making. The tools of
capital budgeting helps the management to make decisions relating to capital investments. The investments made in these projects are huge and
hence it is important to evaluate these projects in order to ensure profits for the organisation.
In the given case we have Leadall Corp, which is trying to evaluate an upcoming opportunity of making FP17, which is expected to generate
profits for the company. In order to evaluate this project, we have used tools such as Net present value and discounted pay-back period to help us
evaluate the feasibility of the project. (Goel, 2015)
5

Findings
Quantitative
Evaluating the Net Present Value of the Project
Net present value is one of the most commonly used tools of decision making. Under this system, the cash flows for a given project are
estimated. These estimates are required to be made on various assumptions and keeping other factors in mind which could affect these cash
flows. Theses cash flows are then summed together in order to arrive at the cash flows at the end of each year of the project (Peterson and
Fabozzi, n.d.). These are then discounted using the appropriate and most suitable cost of capital. When the positive discounted cash flows are
greater than the negative cash flows, the project is said to create value and considered viable. When the negative discounted cash flows are
greater than positive discounted cash flows, the project is not considered viable and is rejected. (Shapiro, n.d.)
The Net Present Value Calculation of the Project has been shown below:
In the given case we see that the net present value of project FP17 results in positive $ 25,69,178, at the given cost of 20%. This means that
company would earn $ 2.5 million in the period of five tears form the said project. Since the net present value is positive the project should be
accepted.
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
6

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
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:
7

- The expenditure of $150000 is in the nature of sunk cost and has not been considered while making the decision.
- assumed that no credit for import duty shall be available to the company. Hence total import duty and transportation cost has been made part
of the cost of machinery.
- the whole of working capital has been deemed to recovered at the end of 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
8

Evaluating the Pay-back period of the Project
Pay-back period is another tool of capital budgeting that helps to evaluate the project. Pay-back period can be defined as the period in which the
investments made can be recovered by the company. There are two types of pay-back period, one is general pay back and the other is discounted
pay back period. Pay-back period helps to calculate the time taken by the project to earn the investment made. The cash flows from the project
after this period is the profit earned. Under the general pay-back period, normal cash flows are taken into consideration, whereas in the
discounted pay back period, we take the discounted cash flows. (Clark, Hindelang and Pritchard, n.d.)
In the given case we see that the management of Leadall Corp required the project to have a discounted pay-back of 4 years. See the table for
discounted cash flows we see that the whole of the investments, made are recovered in the 4 year of the project. Therefore, the management
requirement for the pay-back to be 4 years is satisfied. Therefore, taking the result of discounted pay back into consideration, we can say that the
project can be accepted. (Dayananda, 2008)
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
9

Qualitative
There are also qualitative factors which must be kept in mind before acceptance of the project. Few of these factors have been presented below:
- Availability of funds: Capital budgeting projects require huge investments amount. It is important for the organisation to keep available the
funds. Lack of financing during the execution of project may result in failure and loss to the organisation.
- Working Capital Requirements: the projects require working capital investments. Working capitals serve as blood flow for the
organisation. Lack of which may hamper the operating efficiency of the organisation.
- Capital Return: the return expectations from these kinds of project are relatively higher. Economy is volatile and any factor may harm the
project which may result in the failure of the project. (Herbst, n.d.)
- Government Policies: the government policies affect the working of an organisation to a great effect. It is necessary for the management to
look at the government policies related to the projected plan. It is important to have all the legal compliances be satisfied in order to carry the
project without any obstacles.
- Inapt Assumptions: Capital Budgeting decisions are required to be made based on a lot of assumptions. It is important to make these
assumptions on solid ground based on available evidence. Use of inapt assumptions in the process of capital budgeting may result in wrong
projection of the expected result. (Jacobs, 2008)
- Issues in calculating the appropriate cost of capital: cost of capital is the most important quantitative figure which helps in the process of
decision making. A wrong cost of capital may result in wrong projection of results. It is not necessary that the existing cost of capital would
suit the project. The management may need to calculate a new rate in order to continue the project. Calculation of which is very tiring and a
lengthy process.
10

Therefore, not only quantitative but the qualitative factors are also to be taken into consideration before accepting a project.
11

Recommendation and Justification
- Decision as to accept or reject the project
As per our discussion above we see that the net present value for the said project is positive. Also the pay back requirement of pay-back period
of the management has been satisfied by the given project (Capital Budgeting Valuation, 2013). Therefore, we can say that the project seems
viable and the management should accept the project. This decision of acceptance of project is based on the quantitative analysis (Wilkes, n.d.).
- Evaluating the expense made on Research & Development
The managing director of Leadall Corp wants to evaluate the expense made on research and Development by contributing form this project. We
need to comment on the viability of the project after 3% of its sales revenue is implemented in this ongoing R & D of the company.
We have calculated the net present value of the said project along with the discounted pay-back period, in order to determine the effect of this
expense on the viability of this project. (Bedi, n.d.)
When we allocate the 3% of the sales revenue to the R & D expense we see that the net present value of the project falls from $25,69,178 to $
25,09,178. The pay-back period is not much affected and remains approximately 4 years as required by the management. The NPV of the project
still remains positive and hence viable for the company.
Therefore, we can say that the company is wants can take a part of contribution for the R & D form the sales revenues earned from FP17 project.
The project would continue to be viable for the company and would earn those profits.
12