Analysis Of Capital Project Using Capital Budgeting Techniques

Statement showing calculation of cash inflows and present value of capital project

In this assignment analysis of capital project with the help of capital budgeting techniques has been done. Net present value and payback period has been calculated of the device part capital project. Net present value measures profit of capital project and payback period measures liquidity of the capital project. In second section of this report, analysis of capital budgeting techniques in terms of average risk has been undertaken. JB Hi-Fi is the business organisation that has been taken for analysis in second section. Assessment of working capital in terms of cash conversion cycle has been undertaken. In this assignment, analysis of credit risk that commercial papers has been undertaken. Different types of asset financing policy has been analysed and advantage of aggressive asset financing policy over other policies has been undertaken.

Statement showing calculation of cash inflows from the device part project

Particulars	Year 1	Year 2 Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	Year 3	Year 4	Year 5	Total
Sales revenue	$ 4000000	$ 4400000	$ 4840000	$ 4114000	$ 3496900	$ 20850900
Variable cost	($ 2000000)	($ 2200000)	($ 2420000)	($ 2057000)	($ 1748450)	($ 10425450)
Fixed cost	($1500000)	($1530000)	($1560600)	($1591812)	($1623648)	($ 7806060)
Depreciation	($ 160000)	($ 160000)	($ 160000)	($ 160000)	($ 160000)	($ 800000)
Profit before tax	$ 340000	$ 510000	$ 699400	$ 305188	$ (35198)	$ 1819390
Tax 30 %	$ 102000	$ 153000	$ 209820	$ 91556	$ (10559)	$ 545817
Profit after tax	$ 238000	$ 357000	$ 489580	$ 213632	$ (24639)	$ 1273573
Add: Depreciation	$ 120000	$ 120000	$ 120000	$ 120000	$ 120000	$ 600000
Cash inflows	$ 358000	$ 477000	$ 609580	$ 333632	$ 95361	$ 1873573

Statement showing calculation of present value of the part device project

Particulars	Year – 0	Year -1	Year -2	Year -3	Year -4	Year -5	Total
Cash outflow	$ (800000)	–	–	–	–	–	$ (800000)
Consultants fee	$ (75000)	–	–	–	–	–	$ (75000)
Working capital	–	–	$ (400000)	$ (440000)	$ (484000)	$ (411400)	$ (1735400)
Total cash outflow	$ (875000)	–	$ (400000)	$ (440000)	$ (484000)	$  411400)	$ (2610400)
Cash inflows	–	$ 358000	$ 477000	$ 609580	$ 333632	$ 95361	$ 1873573
Salvage value	–	–	–	–	–	$ 200000	$ 200000
Working capital	–	–	–	–	–	$ 1735400	$ 1735400
Net cash flows	$ (875000)	$ 358000	$ 77000	$ 169580	$ (150368)	$ 1619361	$ 1226573
PV Factor @ 14%	1	0.877	0.769	0.675	0.592	0.519
Cumulative cash inflows	$ (875000)	$ (517000)	$ (440000)	$ (270420)	$ (420788)	$ 198573
Present value of net cash flows	$ (875000)	$ 313966	$ 59213	$ 114467	$ (89018)	$ 840448	$ 364076

(Ghiami and Beullens, 2016)

NPV= PV of cash inflows ($ 1,239,076) – PV of cash outflows ($ 875,000) =$ 364,076

Payback period = 4 years + ($ 875,000 – $ 454,212) / $ 1,619,361

4 years + $ 420,788 / $ 1,619,361 = 4.26 years

Present value of cash inflow @ 14 % = $ 1,239,076

Present value of cash inflow @ 30 % = ($ 93,976)

IRR = LPVF + (Present Value of LPVF – Cash outflow) / (PV of LPVF – PV of HPVF) * [HPVF – LPVF]

LPVF = Lower present value factor and HPVF = Higher present value factor

(Baker and English, 2011)

14 % + [($ 1,239,076 – $ 875,000) / ($ 1,239,076 – ($ 93,976) x (30 % – 14 %)]

14 % + [$ 364,076 / ($ 1,333,053) * 16] = 18.368 %

Depreciation = Cost of asset * (asset held days in a year ÷ 365 days) * (100% ÷ Life of asset)

$ 800000 * 365 days / 365 days * (100 % ÷ 5 years) = $ 160000

Capital Project (Conveyer System)

Year		System A	After tax	Present value	System B	After tax	Present value	System C	After tax	Present value
1	0.877	$13000	$9100	$ 10376	$ 9000	$ 6300	$ 7184	$ 1400	$ 980	$ 1117
2	0.769	$13000	$9100	$ 11834	$ 9000	$6300	$ 8192	$ 1400	$ 980	$ 1274
3	0.675	$13000	$9100	$ 13481	$ 9000	$6300	$ 9333	$ 1400	$ 980	$ 1452
4	0.592	$13000	$9100	$ 15372	$ 9000	$6300	$ 10642	$ 1400	$ 980	$ 1655
5	0.519	$13000	$9100	$ 17534	$ 9000	$6300	$ 12139	$ 1400	$ 980	$ 1888
6	0.456	$13000	$9100	$ 19956	$ 9000	$6300	$ 13816	$ 1400	$ 980	$ 2149
7	0.4	$13000	$9100	$ 22750	$ 9000	$6300	$ 15750	$ 1400	$ 980	$ 2450
8	0.351	$13000	$9100	$ 25926	$ 9000	$6300	$ 17949	$ 1400	$ 980	$ 2792
9	0.308	$13000	$9100	$ 29545	$ 9000	$6300	$ 20455	$ 1400	$ 980	$ 3182
10	0.27	$13000	$9100	$ 33704	$ 9000	$6300	$ 23333	$ 1400	$ 980	$ 3630
11	0.237							$1,400	$ 980	$ 4135
12	0.208							$1,400	$ 980	$ 4712
13	0.182							$1,400	$ 980	$ 5385
14	0.16							$1,400	$ 980	$ 6125
15	0.14							$1,400	$ 980	$ 7000
16	0.123							$1,400	$ 980	$ 7967
17	0.108							$1,400	$ 980	$ 9074
18	0.095							$1,400	$ 980	$ 10316
19	0.083							$1,400	$ 980	$ 11807
20	0.073							$1,400	$ 980	$ 13425
				$ 200478			$ 138792			$ 101535

In this memo, analysis of two capital projects has been analysed and recommendations regarding acceptance and rejection of capital decisions. Capital Budgeting Techniques of net present value has been used and decisions are based on same.

Capital project are required to be evaluated in terms of its profitability, liquidity and solvency position. Following techniques has been used for evaluating capital project:

Net present value- NPV is the capital budgeting method that is used to calculate profits from the project in real value terms. Positive NPV denotes profit in the undertaken project and negative NPV denotes loss in capital project. In present case, there is positive NPV therefore project shall be accepted (Leyman and Vanhoucke, 2017).

Payback period- This the period of time within which cash outflow of the capital project are earned back in the form of cash inflows. Lower payback period shall be accepted and project having higher payback period shall be rejected (Lin and Chung, 2015). Payback period of project is at higher side therefore this is negative point. On the basis of payback period, project shall be rejected.

Net Present Value

Internal rate of return-   It is the rate defined in percentage terms at which present value of cash inflows are equal to present value of cash outflows (Percoco and Borgonovo, 2011). If IRR is less then cost of capital of the project then project shall be rejected and vice versa. Recommendation: Capital project of device part project shall be accepted.

Following are total cost that will be incurred on different conveyer system:

System A= $ 200478

System B = $ 138,792

System C = 101,535

Another capital investment that is taken into consideration is of conveyer system. According to calculations, System C shall be accepted.

Capital project	Procurement of equipment	Life of project = 5 years
Cash flow	1st year to 3rd years  = $ 400,000 4th year and 5th year = $ 300,000	Investment size = $ 1500000 – $ 2000000

JB Hi-Fi is the business organization established in Australia under retail industry. Main business line of JB Hi-Fi is electronic products that are consumed by customers throughout Australia. JB Hi-Fi has reported its Earnings before interest and tax of $ 152.20 million in the year ending 2016. Average risk capital budgeting project can be defined as the level of change in project estimates or in its cash flows. Beta of the JB Hi-Fi is 2 times therefore there is high level of risk involve in any capital project undertaken by JB Hi-Fi. Beta of the business organizations are based on market rates and market fluctuations. NPV of the capital project is largely depends its estimated cash inflows and cost of capital. Beta of JB Hi-Fi will impact cost of capital and estimated cash flows   of the capital project undertaken by JB Hi-Fi (Keef and Roush, 2012). Nature and extend of capital project also made impact on NPV of the project. Nature and size of capital project also impact cash flows and ultimately NPV (Santandrea and Giorgino, 2017).

Statement showing cash conversion cycle of JB Hi-Fi: 

Particulars	2016 (in days)	2015 (in days)
Days sales outstanding	8.29	7.61
Days inventory	60.57	59.95
Payables period	32.84 day	31.86 day
Cash conversion cycle	36.02	35.70

Statement showing cash conversion cycle comparison of JB Hi-Fi and Amazon:

Companies	2016	2015
JB Hi-Fi	36.02 days	35.70 days
Amazon	-29.82 days	-26.12 days

In order to analyse working capital of JB Hi-Fi, cash conversion cycle shall be used as base for analysis. Cash conversion cycle is the period of time stated in terms of days within which cash is collected from sales made during the period (Cagle, Campbell & Jones, 2013). It is calculated by analysing sales days outstanding (sales revenue remains outstanding as debtors), inventory days outstanding and payables periods. As compared to Amazon (competitor of JB Hi-Fi) it has adverse cash conversion cycle or in other words worst working capital management. Therefore management of JB Hi-Fi shall required to manage their cash conversion cycle either by increasing sales outstanding period or inventory period or by decreasing payable period for the reporting period (Shahbazi and Nazaripour, 2015).

Commercial papers are a short term source of financial for the business organization for managing their working capital requirements and for the management liquidity in the business operations. In this case of Telstra has issued commercial papers for managing their short term liquidity and to support working capital, therefore this shows risk in terms of rollover risk i.e. when Telstra is not able to sell new commercial papers at the time of maturity of already issued paper and they are not available with liquidity or liquid assets (Ellison and Tischbirek, 2014). Commercial papers are highly risky and expensive form of source of finance. As maturity of commercial papers are very less and used by the business organization only at the time of emergency.

Payback period

In case of Telstra Limited, management has been using very aggressive short term asset financing policy or strategy. Hedging asset financing policy, aaggressive asset financing, highly aggressive asset financing policy and conservative strategy are four asset financing policy.

Telstra limited has used aggressive short term asset financing policy in order to back their short term assets. Aggressive short term asset financing policy is used by business organization in order to maintain their short term liquidity or short term working capital floating in the business operations of entity (Al-Abedallat, 2016). Same has been used by Telstra Limited for financing short term assert i.e. by issuing commercial papers which are highly risky and short term financing need.

With the help of aggressive short term asset financing policy business cycle or cash conversion cycle can be improved. Since Telstra limited has been using commercial papers (short term finance) for its seasonal requirement or for short term working capital requirement. Hedging asset financing at this moment does not work as it will focus on match asset and liabilities on both long terms and short term basis. On the other hand, conservatism asset financing policy support financing through long term sources of finance. But these are not adequate for financing short term assets or managing liquidity of the business operations. At last, highly aggressive asset financing policy used here is more adequate as compared to hedging policy in terms of quick liquidity management that aggressive asset financing policy provided, hedging policy is not able to provide at that level.

Conclusion

After analysis of this assignment, it can be concluded that there are majorly two capital budgeting techniques that can be sued to evaluate capital projects. Capital projects can be evaluated both in terms of cash inflows and cash outflows from the project. In this case, it can be concluded that management of Initect limited has applied net present value and payback period capital budgeting technique for evaluating capital project of the device part project. Net present value of project is positive, therefore project shall be accepted. Equivalent annual net present value of cash out flows has been determined and system C has been selected as it has lowest cost. JB Hi-Fi is the company that has been analyzed in this report in terms of average risk capital budgeting project undertaken by the company. At last analysis of issue of commercial paper suggests aggressive asset financing policy of the Telstra Limited. 

References

Al-Abedallat, A., 2016, Factors affecting credit risk: An empirical study of the Jordanian commercial banks. European Scientific Journal, vol 12, no 34, p 307.

Baker, H., & English, P., 2011, Capital Budgeting Valuation Financial Analysis for Today’s Investment Projects (Robert W. Kolb Series). Chichester: Wiley.

Baker, H., & English, P., 2011, Capital Budgeting Valuation Financial Analysis for Today’s Investment Projects (Robert W. Kolb Series). Chichester: Wiley.

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Ellison, M., & Tischbirek, A., 2014, Unconventional government debt purchases as a supplement to conventional monetary policy. Journal of Economic Dynamics & Control, vol 43, p 199.

Ghiami, & Beullens., 2016, Planning for shortages? Net Present Value analysis for a deteriorating item with partial backlogging. International Journal of Production Economics, vol 178, pp 1-11.

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Lin, Chang, & Chung., 2015, Payback period for residential solar water heaters in Taiwan. Renewable and Sustainable Energy Reviews, vol 41, pp 901-906.

Percoco, & Borgonovo., 2011, A note on the sensitivity analysis of the internal rate of return. International Journal of Production Economics.

Santandrea, Sironi, Grassi, & Giorgino., 2017, Concentration risk and internal rate of return: Evidence from the infrastructure equity market. International Journal of Project Management, vol 35, no 3, pp 241-251.

Shahbazi, S., & Nazaripour, M., 2015, The relationship between cash conversion cycle and economic value added in Tehran stock exchange. P 392.