Capital budgeting decision is one of the most widely used decision making tool. We are provided with a decision making case for a company PENTAG, in which the management is to take important decision regarding production of one or other type of product. In our discussion in the below report, we have implement qualitative and quantitative research on the options available with the company. Based on both the aspects the company is required to the final decision.
The company has the option of producing Q-powerboats. The management of the company after detailed study has been able to collect financial data on the expected cash flows of the company. We have conducted capital budgeting technique in respect to this proposal in order to come to conclusion on financial viability of the project.
We have calculated the net present value of the said project. Net present value is the capital budgeting tool under which the difference between the present values of cash outflows are deducted from present value of cash inflows (Adelaja, 2015). This represents the excess cash flow earned over invested amount. If the amount is positive then the project seems viable and should be accepted, but if the project NPV is negative it should be rejected. NPV is calculated using the following formula:
The net present value of the investment opportunity for PENTAG for production of Q-Power board with a required of 20% resulted in $5812640. This indicates that the project is likely to generate value for the company. Based on these calculations, the project is expected to create value for the company and should be accepted.
Pay-back period is the capital budgeting tool that helps the investor determine the time period within which the invested amount in a project will be recovered (Bierman & Smidt, 2010). For example, we have a project with life of 5 years, which requires 10000 investments in the beginning, the pay-back period will calculate the time span within which this invested amount of $ 10000 will be recovered from the cash flow of the project. Pay-back period is calculated using the following formula:
|
Pay-back period |
= |
a+(b/c) |
|
Where, |
||
|
A |
= |
the period with last negative cumulative cash flow |
|
B |
= |
the amount of last cumulative cash flow |
|
C |
= |
the cash flow just after the period a |
The pay-back period of the said project amounted to 2.53 years. The required pay-back for this project by the management is 4 years. Therefore, we see that the company will recover its invested amount before its required time. Based on this the project seems worthy of acceptance.
Internal rate of return is the hidden rate of return that is actually earned on the project. The internal rate is calculated by equating the cash outflows and inflow, then using the method of trial and error the hidden rate of return in calculated (Datar, 2016). If IRR is more than the required rate of return then the project should be accepted and if it is lower than it should be rejected. For the given project of production of Q-Powerboats the internal rate of return is 31%. Since the IRR is more the required return the project should be accepted.
Besides the financial aspects, there are other qualitative factors also which the company should take into consideration before accepting a new project. (Seitz & Ellison, 2009) Few of these factors have been discussed in the below report:
Therefore, before a new project is executed, it is important that the management studies all the aspects properly. (Shapiro, 2007)Effect of all major factors should be consideration before taking the final capital budgeting decision.
Capital budgeting decision is based on a lot of detailed investigation. (Peterson & Fabozzi, 2012) There are various rules and regulations which are required to be followed in order to evaluate the feasibility of the project properly. For example, the expense which been already incurred by the company on market research and project development have not taken into consideration while taking the decision. This is so because these expenses have already been incurred and the decision o f acceptance or rejection of project will not affect the expense. These expenses are sunk cost, and are not considered in evaluating the capital budgeting projects. (Siciliano, 2015)
Taking all the above data into consideration we can see that the project is to create value for the company. It is expected to generate profits up to $5.8 million. The pay- back period of the project is lesser than the required pay-back period by the managers. Hence, we would recommend the management to accept the project of production of Q-powerboats.
The management has been approached by an environmental group to take into consideration another project of S-powerboats in place of Q power boats, since they are environmental friendly. The management wants to do a comparative study on the resulted of both the projects. In our discussion below we have made a detailed study on comparative results of both the projects.
We have conducted net present value analysis of both the project at the required return of 20 % and 25%. The project which provides the highest return to the company should be opted for. The following table shows the NPV results from both the projects:
|
Particulars |
S-Power Boats |
|
|
NPV @ 20% |
58,12,640 |
11,65,321 |
|
NPV @ 25% |
27,86,179 |
-17,31,545 |
We see that the company is expected to have positive net present value form production of Q-powerboats with the required return of both 20% and 25%. But the project of s power boats are to have positive NPV only when the required return is 20%, if the company has a required return of 25% the project will have negative NPV. From the above table we can see the NPV for the company is earned with production of Q-Power boats when its required rate of return is 20%. Therefore, company should opt for production of Q –power boats since it would get higher returns with same investment in this option.
Also if we calculate the internal rate of return for both the project we see that the IRR for production of Q power boats is 31% and that of S-Power boats is 22%. Therefore, since IRR is more for production of Q-Power boats, this project should be opted for.
The crossover rate is the rate for which the net present values for two similar projects are same. (Rivenbark, Vogt, & Marlowe, 2009) It is the point at which either of the projects can be opted for when we calculate the crossover rate for both of the projects we get the rate to be -19%. This means that when the required rate of return by the company will be -19% the net present value of both the projects will be same.
Conclusion
From the above analysis we are clear that the company should opt for production of Q power boats. The company should take into consideration all the qualitative and quantitative factors into consideration before executing the final plan. Since the capital budgeting decisions are based on a lot of assumptions the company should keep a margin for uncertainties also.
Adelaja, T. (2015). Capital Budgeting: Investment Appraisal Techniques Under Certainty. Chicago: CreateSpace Independent Publishing Platform .
Bierman, H., & Smidt, S. (2010). The Capital Budgeting Decision. Boston: Routledge.
Datar, S. (2016). Horngren’s Cost Accounting: A Managerial Emphasis. Hoboken: Wiley.
Dayananda, D., Irons, R., Harrison, S., Herbohn, J., & Rowland, P. (2008). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press.
Holtzman, M. (2013). Managerial Accounting For Dummies. Hoboken, NJ: Wiley.
Menifield, C. E. (2014). The Basics of Public Budgeting and Financial Management: A Handbook for Academics and Practitioners. Lanham, Md.: University Press of America.
Noreen, E. (2015). The theory of constraints and its implications for management accounting. Great Barrington, MA: North River Press.
Peterson, P. P., & Fabozzi, F. J. (2012). Capital Budgeting. New York, NY: Wiley.
Rivenbark, W. C., Vogt, J., & Marlowe, J. (2009). Capital Budgeting and Finance: A Guide for Local Governments. Washington, D.C.: ICMA Press.
Seitz, N., & Ellison, M. (2009). Capital Budgeting and Long-Term Financing Decisions. New York: Thomson Learning.
Shapiro, A. C. (2007). Capital Budgeting and Investment Analysis. New Jersey: Wiley.
Siciliano, G. (2015). Finance for Nonfinancial Managers. New York: McGraw-Hill.
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