Introduction
Pentag Company manufactures small powerboats and at present facing challenges in building and marketing green powerboats environment friendly. As per the view of the entity’s director building of green powerboat is possible however, the market condition and demand are not optimum at present. The report will analyse the profitability and acceptability of new project Q-powerboat that is being considered by the entity at present for manufacture. In addition to that Pentag has another project to consider that is S-Powerboat that is considered to be more environment friendly as compared to Q-Powerboat (Baddeley 2017)
Findings
Computation for Q-Powerboat
| Analysis of Q-Powerboat | |||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
| Cost of equipment | $ -20,000,000.00 | ||||||
| Installation cost of equipment | $ -800,000.00 | ||||||
| Sales in units | 650.00 | 600.00 | 550.00 | 500.00 | 450.00 | 400.00 | |
| selling price per unit | $ 30,000.00 | $ 30,000.00 | $ 30,000.00 | $ 30,000.00 | $ 30,000.00 | $ 30,000.00 | |
| Sales revenue | $ 19,500,000.00 | $ 18,000,000.00 | $ 16,500,000.00 | $ 15,000,000.00 | $ 13,500,000.00 | $ 12,000,000.00 | |
| Variable cost | $ -7,800,000.00 | $ -7,200,000.00 | $ -6,600,000.00 | $ -6,000,000.00 | $ -5,400,000.00 | $ -4,800,000.00 | |
| Fixed cost | $ -200,000.00 | $ -200,000.00 | $ -200,000.00 | $ -200,000.00 | $ -200,000.00 | $ -200,000.00 | |
| Depreciation | $ -2,496,000.00 | $ -2,496,000.00 | $ -2,496,000.00 | $ -2,496,000.00 | $ -2,496,000.00 | $ -2,496,000.00 | |
| opportunity sales revenue | $ 500,000.00 | $ 500,000.00 | $ 500,000.00 | $ 500,000.00 | $ 500,000.00 | $ 500,000.00 | |
| Cost of production | $ -200,000.00 | $ -200,000.00 | $ -200,000.00 | $ -200,000.00 | $ -200,000.00 | $ -200,000.00 | |
| Opportunity loss on earnings | $ -10,000.00 | $ -10,000.00 | $ -10,000.00 | $ -10,000.00 | $ -10,000.00 | $ -10,000.00 | |
| Working capital | $ -700,000.00 | ||||||
| Cash flow before tax | $ -21,500,000.00 | $ 9,294,000.00 | $ 8,404,000.00 | $ 7,494,000.00 | $ 6,604,000.00 | $ 5,694,000.00 | $ 4,804,000.00 |
| Tax @ 30% | $ – | $ -2,788,200.00 | $ -2,521,200.00 | $ -2,248,200.00 | $ -1,981,200.00 | $ -1,708,200.00 | $ -1,441,200.00 |
| Cash flow after tax | $ -21,500,000.00 | $ 6,505,800.00 | $ 5,882,800.00 | $ 5,245,800.00 | $ 4,622,800.00 | $ 3,985,800.00 | $ 3,362,800.00 |
| Add: Salvage value | $ 3,000,000.00 | ||||||
| Add: Depreciation | $ 2,496,000.00 | $ 2,496,000.00 | $ 2,496,000.00 | $ 2,496,000.00 | $ 2,496,000.00 | $ 2,496,000.00 | |
| Free cash flow | $ -21,500,000.00 | $ 9,001,800.00 | $ 8,378,800.00 | $ 7,741,800.00 | $ 7,118,800.00 | $ 6,481,800.00 | $ 8,858,800.00 |
| Discounting factor @ 20% | 1 | 0.83 | 0.69 | 0.58 | 0.48 | 0.40 | 0.33 |
| Discounted cash flow | $ -21,500,000.00 | $ 7,501,500.00 | $ 5,818,611.11 | $ 4,480,208.33 | $ 3,433,063.27 | $ 2,604,890.05 | $ 2,966,794.20 |
| Discounting factor @ 25% | 1 | 0.80 | 0.64 | 0.51 | 0.41 | 0.33 | 0.26 |
| Discounted cash flow | $ -21,500,000.00 | $ 7,201,440.00 | $ 5,362,432.00 | $ 3,963,801.60 | $ 2,915,860.48 | $ 2,123,956.22 | $ 2,322,281.27 |
| At 20% disc rate | At 25% disc rate | |
| NPV | $ 5,305,066.96 | $ 2,389,771.57 |
| IRR | 30% | 30% |
| Discounted payback period | 4.10 | 4.97 |
Quantitative characteristic
From above table and outcomes following analysis can be made –
- Net present value – NPV is an investment appraisal technique used for determining current value of all the future cash inflows that is the estimated future cash flows from the project after deducting the amount of initial expenses spend for acquiring the project. When NPV technique is used to evaluate the project’s acceptability, positive NPV indicates that the project is acceptable. On the contrary, the negative NPV indicates that the project is not acceptable (Žižlavský 2014). From the computation it is clear that the Q-Powerboat project is generating positive NPV amounting to $ 53,05,066.96 applying 20% WACC. Hence, based on the outcome of NPV the project is acceptable.
- Discounted payback period – it is a capital budgeting approach used for computing project’s acceptability. It provides the investor with the time period required for covering up the amount of initial expenses spend for acquiring the project. When DPP technique is used to evaluate the project’s acceptability, DPP of less than the project’s life time indicates that the project is acceptable. On the contrary, the DPP of more than the project’s life time indicates that the project is not acceptable (Qiu, Wang and Wang 2015). From the computation it is clear that the Q-Powerboat project’s initial investment will be recovered in 4.10 years that is lower than its life time of 6 years applying 20% WACC. Hence, based on the outcome of DPP the project is acceptable.
- Internal rate of return – it is the core component of capital budgeting approach and is used to evaluate the project’s rate of return. When IRR technique is used to evaluate the project’s acceptability, IRR of more than the WACC indicates that the project is acceptable. On the contrary, the IRR of less than the WACC indicates that the project is not acceptable (DeFusco et al. 2015). From the computation it is clear that the Q-Powerboat project’s IRR is 30% that is more than its WACC of 20%. Hence, based on the outcome of IRR the project is acceptable.
Qualitative characteristics
Taking into consideration all the above mentioned factors and outcomes it is identified that the project is fulfilling all the aspects required for accepting any project. However, one attached condition of the entity for accepting the project is the DPP shall not be more than 4 years. However, it is found from the outcomes that the DPP of the project at 20% WACC is 4.10 years that is more than the required time period of 4 years. Hence, as the project is not fulfilling the requirement of payback period it is not acceptable
Computation for S-Powerboat
| Analysis of S-Powerboat | |||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
| Free cash flow | $ -21,500,000.00 | $ 6,400,000.00 | $ 7,400,000.00 | $ 7,900,000.00 | $ 8,600,000.00 | $ 9,300,000.00 | $ 11,100,000.00 |
| Discounting factor @ 20% | 1 | 0.83 | 0.69 | 0.58 | 0.48 | 0.40 | 0.33 |
| Discounted cash flow | $ -21,500,000.00 | $ 5,333,333.33 | $ 5,138,888.89 | $ 4,571,759.26 | $ 4,147,376.54 | $ 3,737,461.42 | $ 3,717,367.54 |
| Discounting factor @ 25% | 1 | 0.80 | 0.64 | 0.51 | 0.41 | 0.33 | 0.26 |
| Discounted cash flow | $ -21,500,000.00 | $ 5,120,000.00 | $ 4,736,000.00 | $ 4,044,800.00 | $ 3,522,560.00 | $ 3,047,424.00 | $ 2,909,798.40 |
| At 20% disc rate | At 25% disc rate | |
| NPV | $ 5,146,186.99 | $ 1,880,582.40 |
| IRR | 28% | 28% |
| Discounted payback period | 4.62 | 5.35 |
Comparison
| Q-Powerboat | S-Powerboat | |||
| At 20% disc rate | At 25% disc rate | At 20% disc rate | At 25% disc rate | |
| NPV | 5305066.958 | 2389771.571 | 5146186.986 | 1880582.4 |
| IRR | 30% | 30% | 28% | 28% |
| Discounted payback period | 4.10 | 4.97 | 4.62 | 5.35 |
As the entity is facing some issues regarding high carbon emission by Q-Powerboat and is considering undertaking S-Powerboat that is considered to be more environment friendly as compared to Q-Powerboat. Cash outflows of S-Powerboat are same as Q-Powerboat, however, the cash flow for its useful life that is for 6 years period vary from Q-Powerboat. From the computation it is clear that the S-Powerboat project is generating positive NPV amounting to $ 51,46,186.99 applying 20% WACC and $ 18,80,582 applying WACC of 25%. Hence, based on the outcome of NPV the project is acceptable. From the computation of DPP it is clear that the S-Powerboat project’s initial investment will be recovered in 4.62 years when WACC is 20% and in 5.35 years when WACC is 25% that is lower than its life time of 6 years. Hence, based on the outcome of DPP the project is acceptable. Further, it is clear that the S-Powerboat project’s IRR is 28% that is more than its WACC of 20% as well as 25% both. Hence, based on the outcome of IRR the project is acceptable (Dhavale and Sarkis 2018). Taking into consideration all these factors and outcomes it is identified that the project is fulfilling all the aspects required for accepting any project. However, as per the attached condition for accepting the project, DPP shall not be more than 4 years. However, it is found from the outcomes that the DPP of the project at 20% WACC is 4.62 years and at 25% WACC it is 5.35 years, hence both are more than the required time period of 4 years. Hence, as the project is not fulfilling the requirement of payback period it is not acceptable.
Cross over rate
Cross over rate is the rate at which NPV of one project crosses over NPV of another project. It is useful in analysis of capital budgeting as it states the rate at which the NPV of mutually exclusive project is same. If the cost of capital crosses the cross over rate the acceptability of the project alters. For instance, if project is acceptable at below rate of cross over rate, project B becomes acceptable while the cost of capital exceeds the cross over rate (Corporate Finance Institute 2019). From the computation shown below it can be found that the crossover rate of the projects is 18%.
| Year | Free Cash flow | Difference | |
| Q-Powerboat | S-Powerboat | ||
| 0 | $ -21,500,000.00 | $-21,500,000.00 | $ – |
| 1 | $ 9,001,800.00 | $ 6,400,000.00 | $ 2,601,800.00 |
| 2 | $ 8,378,800.00 | $ 7,400,000.00 | $ 978,800.00 |
| 3 | $ 7,741,800.00 | $ 7,900,000.00 | $ -158,200.00 |
| 4 | $ 7,118,800.00 | $ 8,600,000.00 | $ -1,481,200.00 |
| 5 | $ 6,481,800.00 | $ 9,300,000.00 | $ -2,818,200.00 |
| 6 | $ 8,858,800.00 | $ 11,100,000.00 | $ -2,241,200.00 |
| Cross-over rate | 18% |
Conclusion and recommendation
It is concluded from the above that both the projects
are satisfying the criteria for accepting the project. However, they are not
fulfilling the criteria of DPP for 4 years as both the projects DPP at both
WACC of 20% and 25% is more than 4 years. Hence, both the projects are not
acceptable and it is recommended that the projects shall not be proceeded
with. However, if the condition of DPP
is not there Q-Powerboat is better as compared to S-Powerboat as its IRR and
NPV is more than S-Powerboat.
Reference and bibliography
Baddeley, M., 2017. Investment: Theories and Analyses. Macmillan International Higher Education.
Corporate Finance Institute., 2019. Crossover Rate – Formula, Examples, and Guide to Discount Rate, NPV. [online] Available at: https://corporatefinanceinstitute.com/resources/knowledge/valuation/crossover-rate/ [Accessed 9 May 2019].
DeFusco, R.A., McLeavey, D.W., Pinto, J.E., Anson, M.J. and Runkle, D.E., 2015. Quantitative investment analysis. John Wiley & Sons.
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