CAPITAL BUDGETING DECISION MAKING
- 1. Table of contents:
1. Table of contents: 2
2. Introduction: 3
3. Capital budgeting technique: 4
4. Analysis: 5
5. Assumptions: 8
6. Conclusion: 9
- 2. Introduction:
Change is something that is required in each and everything that exists today. If the business does not change with the changing demands of the customer, then it will decay and terminate.
It was with this thought that the management of Goldstar Corporation thought of introducing a new line of products of dairy products. This would require an extension of the wing of the whole new production and supply chain.
This report aims at discussing the various outflows and the inflows that the new line of product will entail.
- 3. Capital budgeting technique:
Capital budgeting is very crucial when it comes to making the decisions with relation to the acceptance of products.
Capital budgeting is the technique whereby the decision of whether to take an investment or not depends. The investment decisions that involve a considerable period of time in order to mature have to be based upon the returns that would be derived from the investment. Unless and until, the project has been accepted for social reasons sonly, then it should be accepted only if it entails positive cash flows over the period of time.
It is good to know the amount of the present value that the project would provide to the company. (Fao.org 2014)
The following are the techniques that have been used for the evaluation of the new line of the products:
- 1. Net present value:
This is the technique in which the present value of the cash inflows and cash outflows are calculated. Only, if the net present value is positive, then the project must be accepted, otherwise not.
In the given case, the following is the NPV:
| Net present value | -39,04,397.56 |
- 2. Internal rate of return:
The internal rate of return is the return on an investment or a project that is the annualised effective compounded rate of return. In other words, it is the discount rate that makes the net present value of all the cash flows from the particular investment to 0.
(Princeton.edu 2014)
When the internal rate of return is calculated for the new line of product, then the following rate of return is calculated:
| Internal rate of return | 5.793% |
- 4. Analysis:
The following are the calculated values:
| Statement of incremental cash flows: | (Amounts in $) | |||||
| Particulars | Workings | Amount | Year | PV factor | Present value | |
| Cash inflows: | ||||||
| Incremental annual sales value: | ||||||
| Year 1 | 2,50,000.00 | 1.00 | 0.89286 | 2,23,214.25 | 2,50,000.00 | |
| Year 2 | 2,50,000.00 | 2.00 | 0.79719 | 1,99,298.25 | 2,50,000.00 | |
| Year 3 | 2,50,000.00 | 3.00 | 0.71178 | 1,77,945.00 | 2,50,000.00 | |
| Decrease in the overall costs | 1,50,000.00 | – | 1.00000 | 1,50,000.00 | 1,50,000.00 | |
| Decrease in the cost due to new dairy products | 15,50,000.00 | – | 1.00000 | 15,50,000.00 | 15,50,000.00 | |
| Increase in the creditors | 30,000.00 | – | 1.00000 | 30,000.00 | 30,000.00 | |
| Tax savings in depreciation: | – | |||||
| Depreciation | 1,31,775.00 | 1,88,250.00 | 1.00 | 0.89286 | 1,68,080.33 | -45,000.00 |
| Depreciation | 1,31,775.00 | 1,88,250.00 | 2.00 | 0.79719 | 1,50,071.58 | -45,000.00 |
| Depreciation | 1,31,775.00 | 1,88,250.00 | 3.00 | 0.71178 | 1,33,992.59 | -45,000.00 |
| Sales of old machine | 40,000.00 | – | 1.00000 | 40,000.00 | 40,000.00 | |
| Initial investment: | – | |||||
| Stock | 60,000.00 | 3.00 | 0.71178 | 42,706.80 | 60,000.00 | |
| Debtors | 40,000.00 | 3.00 | 0.71178 | 28,471.20 | 40,000.00 | |
| Salvage value of the new machine | 3,00,000.00 | 3.00 | 0.71178 | 2,13,534.00 | 3,00,000.00 | |
| Total cash inflows | 31,07,314.00 | |||||
| Cash outflows: | ||||||
| Initial investment: | ||||||
| Stock | 60,000.00 | – | 1.00000 | 60,000.00 | -60,000.00 | |
| Debtors | 40,000.00 | – | 1.00000 | 40,000.00 | -40,000.00 | |
| Cost of the machine | 15,55,000.00 | – | 1.00000 | 15,55,000.00 | -15,55,000.00 | |
| Cost of the samples distributed | 30,000.00 | – | 1.00000 | 30,000.00 | -30,000.00 | |
| Increase in the operating costs | 17,00,000.00 | 1.00 | 0.89286 | 15,17,856.90 | -15,17,865.90 | |
| Increase in the operating costs | 17,00,000.00 | 2.00 | 0.79719 | 13,55,228.10 | -13,55,228.10 | |
| Increase in the operating costs | 17,00,000.00 | 3.00 | 0.71178 | 12,10,026.00 | -12,10,026.00 | |
| Training costs | 40,000.00 | – | 1.00000 | 40,000.00 | -40,000.00 | |
| Additional training costs | 25,000.00 | – | 1.00000 | 25,000.00 | -25,000.00 | |
| Total cash outflows | 58,33,111.00 | -58,33,111.00 | ||||
| Net present value | -39,04,397.56 | |||||
| Internal rate of return | 5.793% | |||||
From the analysis of the above case, we find that the following values:
| Net present value | -39,04,397.56 | ||||
| Internal rate of return | 5.793% |
Both the net present value and the internal rate of return are lower.
The NPV is negative, this means that if the company accepts the launch of this new product line, then the company will only end up in paying more out of its pockets.
Further, the IRR is also lower. Only if the IRR exceeds the cost of capital, then only it would add value to the company.
Keeping in mind the above scenario, the project should not be accepted.
Working note:
| Cost of the new machine: | ||
| Particulars | Amounts in $ | |
| Parts and accessories | 12,00,000 | |
| Transportation cost | 5,000 | |
| Import duty | 1,50,000 | |
| Installation | 2,00,000 | |
| Total cost of the new machine | 15,55,000 | |
- 5. Assumptions:
- The cost that has been incurred in respect of the market survey of $45,000 would be termed as sunk cost since, the obligation of it has already been decided.
- The cost that has been incurred in respect of the old machine of $240,000 would be termed as sunk cost since, the obligation of it has already been decided.
- It has been assumed that the new line of products would remain operational only for 3 years.
- 6. Conclusion:
From the basis of the above, it could be said that the new line of product must not be accepted. If it is accepted, it will only cast a burden on the pockets of the company.
- 7. References:
Fao.org, 2014. ‘Chapter 6 – Investment Decisions – Capital Budgeting’. http://www.fao.org/docrep/w4343e/w4343e07.htm.
Princeton.edu, 2014. ‘Internal Rate of Return’. http://www.princeton.edu/~achaney/tmve/wiki100k/docs/Internal_rate_of_return.html.
| WACC |
12% |
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Statement of incremental cash flows: |
(Amounts in $) | ||||||||||||
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Particulars |
Workings |
Amount |
Year |
PV factor |
Present value |
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Cash inflows: |
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Cost of the new machine: |
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| Incremental annual sales value: | |||||||||||||
| Year 1 | 250,000.00 | 1.00 | 0.89286 | 223,214.25 | 250,000.00 |
Particulars |
Amounts in $ |
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| Year 2 | 250,000.00 | 2.00 | 0.79719 | 199,298.25 | 250,000.00 | ||||||||
| Year 3 | 250,000.00 | 3.00 | 0.71178 | 177,945.00 | 250,000.00 | Parts and accessories | 1,150,000 | ||||||
| Decrease in the overall costs | 150,000.00 | – | 1.00000 | 150,000.00 | 150,000.00 | Transportation cost | 50,000 | ||||||
| Decrease in the cost due to new diary products | 1,550,000.00 | – | 1.00000 | 1,550,000.00 | 1,550,000.00 | Import duty | 150,000 | ||||||
| Increase in the creditors | 30,000.00 | – | 1.00000 | 30,000.00 | 30,000.00 | Installation | 200,000 | ||||||
| Tax savings in depreciation: | – | ||||||||||||
| Depreciation | 131,250.00 | 187,500.00 | 1.00 | 0.89286 | 167,410.69 | -45,000.00 | |||||||
| Depreciation | 131,250.00 | 187,500.00 | 2.00 | 0.79719 | 149,473.69 | -45,000.00 | Total cost of the new machine | 1,550,000 | |||||
| Depreciation | 131,250.00 | 187,500.00 | 3.00 | 0.71178 | 133,458.75 | -45,000.00 | |||||||
| Sales of old machine | 40,000.00 | – | 1.00000 | 40,000.00 | 40,000.00 | ||||||||
| Initial investment: | – | ||||||||||||
| Stock | 60,000.00 | 3.00 | 0.71178 | 42,706.80 | 60,000.00 | ||||||||
| Debtors | 40,000.00 | 3.00 | 0.71178 | 28,471.20 | 40,000.00 | ||||||||
| Salvage value of the new machine | 300,000.00 | 3.00 | 0.71178 | 213,534.00 | 300,000.00 | ||||||||
| Total cash inflows | 3,105,512.63 | ||||||||||||
| Cash outflows: | |||||||||||||
| Initial investment: | |||||||||||||
| Stock | 60,000.00 | – | 1.00000 | 60,000.00 | -60,000.00 | ||||||||
| Debtors | 40,000.00 | – | 1.00000 | 40,000.00 | -40,000.00 | ||||||||
| Cost of the machine | 1,550,000.00 | – | 1.00000 | 1,550,000.00 | -1,555,000.00 | ||||||||
| Cost of the samples distributed | 30,000.00 | – | 1.00000 | 30,000.00 | -30,000.00 | ||||||||
| Increase in the operating costs | 1,700,000.00 | 1.00 | 0.89286 | 1,517,856.90 | -1,517,865.90 | ||||||||
| Increase in the operating costs | 1,700,000.00 | 2.00 | 0.79719 | 1,355,228.10 | -1,355,228.10 | ||||||||
| Increase in the operating costs | 1,700,000.00 | 3.00 | 0.71178 | 1,210,026.00 | -1,210,026.00 | ||||||||
| Training costs | 40,000.00 | – | 1.00000 | 40,000.00 | -40,000.00 | ||||||||
| Additional training costs | 25,000.00 | – | 1.00000 | 25,000.00 | -25,000.00 | ||||||||
| Total cash outflows | 5,828,111.00 | -5,833,111.00 | |||||||||||
| Net present value | -3,905,310.19 | ||||||||||||
| Internal rate of return |
5.793% |
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