Q power boat and S power boat are two projects under consideration which require similar initial and terminal cash flows. However, operating cash flows for the project is different. In addition to this, some other qualitative aspects are also different. This report is written for providing a conclusion for making choice between Q power boat and S power boat after considering qualitative and quantitative aspects. Quantitative aspects are tested by making use of capital budgeting techniques.
Capital budging techniques are used and implemented for managerial decision making. These techniques are helpful in finding more beneficial project under two or more project and it also concludes whether a project should be accepted by the organization or not (Rossi, 2015). Capital budgeting techniques which used for making analysis under consideration are net present value, internal rate of return and discounted cash flow.
Moreover, if the organization needs to make the decision for making choice between two or more projects then net present value technique conclude which project is eligible to create maximum wealth for the organization. This technique calculates surplus or deficit of present value of future expected cash inflows over future expected cash outflows from the project.
Furthermore, if the organization needs to make a decision regarding acceptance or nonacceptance then the internal rate of return technique conclude what return percentage can be provided by the project. Additionally, if the organization needs to make the decision for making choice between two or more projects then the internal rate of return technique conclude which project is having more return percentages.
Furthermore, discount payback technique calculates the period in which discounted cash inflows from the organization could generate initial cash outflows. Project having higher discounted payback period does not consider as an efficient project.
Calculation of initial flow
The initial flow of the project includes the outflow due to plant cost i.e. $ 20,000,000, outflow due to transportation and installment cost of the plant i.e. $ 800,000, initial outflow due to working capital introduction is $ 700,000 and the cash inflow because of the debenture issue is $ 1,000,000. In this way, total initial cash outflow will be $ 11,500,000.
After tax cash inflows due to sale of the plant will be $ 3,671,200, cash inflows due to the release of the working capital from the project at the end of the project will be equal to initial outflow for working capital introduction i.e. $ 700,000 and cash outflow due to repayment of debentures will be equal to the cash inflows due to debentures at the start of this project i.e. $ 1,000,000. In this way, total terminal cash outflow will be $ 5,628,800.
Calculation of operating flow
|
Year |
1 |
2 |
3 |
4 |
5 |
6 |
|
Revenue |
||||||
|
Q-powerboat sale |
$ 19,500,000 |
$ 18,000,000 |
$ 16,500,000 |
$ 15,000,000 |
$ 13,500,000 |
$ 12,000,000 |
|
Power board parts revenue |
$ 500,000 |
$ 500,000 |
$ 500,000 |
$ 500,000 |
$ 500,000 |
$ 500,000 |
|
Total revenue |
$ 20,000,000 |
$ 18,500,000 |
$ 17,000,000 |
$ 15,500,000 |
$ 14,000,000 |
$ 12,500,000 |
|
Less: costs |
||||||
|
Variable cost |
$ 7,800,000 |
$ 7,200,000 |
$ 6,600,000 |
$ 6,000,000 |
$ 5,400,000 |
$ 4,800,000 |
|
Variable cost parts |
$ 200,000 |
$ 200,000 |
$ 200,000 |
$ 200,000 |
$ 200,000 |
$ 200,000 |
|
Depreciation expenses |
$ 2,496,000 |
$ 2,496,000 |
$ 2,496,000 |
$ 2,496,000 |
$ 2,496,000 |
$ 2,496,000 |
|
Fixed factory overhead |
$ 200,000 |
$ 200,000 |
$ 200,000 |
$ 200,000 |
$ 200,000 |
$ 200,000 |
|
Interest expenses |
$ 1,000,000 |
$ 1,000,000 |
$ 1,000,000 |
$ 1,000,000 |
$ 1,000,000 |
$ 1,000,000 |
|
Opportunity cost |
$ 120,000 |
$ 120,000 |
$ 120,000 |
$ 120,000 |
$ 120,000 |
$ 120,000 |
|
Total costs |
$ 11,816,000 |
$ 11,216,000 |
$ 10,616,000 |
$ 10,016,000 |
$ 9,416,000 |
$ 8,816,000 |
|
Operating profit |
$ 8,184,000 |
$ 7,284,000 |
$ 6,384,000 |
$ 5,484,000 |
$ 4,584,000 |
$ 3,684,000 |
|
Tax expenses |
$ 2,455,200 |
$ 2,185,200 |
$ 1,915,200 |
$ 1,645,200 |
$ 1,375,200 |
$ 1,105,200 |
|
Profit after tax |
$ 5,728,800 |
$ 5,098,800 |
$ 4,468,800 |
$ 3,838,800 |
$ 3,208,800 |
$ 2,578,800 |
|
Add: Depreciation |
$ 2,496,000 |
$ 2,496,000 |
$ 2,496,000 |
$ 2,496,000 |
$ 2,496,000 |
$ 2,496,000 |
|
Total After tax operating cash flow |
$ 8,224,800 |
$ 7,594,800 |
$ 6,964,800 |
$ 6,334,800 |
$ 5,704,800 |
$ 5,074,800 |
Calculation of total after tax cash flow and the present value of that cash flows at 20% discount rate from Q powerboat
|
Year |
Initial flow |
Operating flow |
Terminal flow |
Total cash flows |
Present value |
|
0 |
$ (11,500,000) |
$ (11,500,000) |
$ (11,500,000.00) |
||
|
1 |
$ 8,224,800 |
$ 8,224,800 |
$ 6,854,000.00 |
||
|
2 |
$ 7,594,800 |
$ 7,594,800 |
$ 5,274,166.67 |
||
|
3 |
$ 6,964,800 |
$ 6,964,800 |
$ 4,030,555.56 |
||
|
4 |
$ 6,334,800 |
$ 6,334,800 |
$ 3,054,976.85 |
||
|
5 |
$ 5,704,800 |
$ 5,704,800 |
$ 2,292,631.17 |
||
|
6 |
$ 5,074,800 |
$ (5,628,800) |
$ (554,000) |
$ (185,533.48) |
Net present value of the capital budgeting project is the sum of all cash inflows and cash outflows at the present value of such cash inflows and outflows. In the calculation of net present value firstly organization needs to make the calculation of after-tax cash flows from the project then after needs to calculated present value interest factors at the weighted average cost of capital of the organization. Such present value interest factors need to apply to after-tax cash flows and the sum of such after-tax cash flows known as the net present value of the organization’s project under consideration. Higher net present value of any project is more liked in comparison to the project having lower net present value (Abor, 2017).
The internal rate of return on any project is a return rate at which net present of the organization become zero. It is the rate of return provided by the project to the organization. The internal rate of return for the project having life more than 2 years can only be calculated by using hit and trial method or using excel spreadsheet calculations. A project having a higher internal rate of return is assumed as a better project and accepted by the organization over the project having a lower internal rate of return.
The payback period of any project is a period in which initial after-tax cash outflows of the organization can be paid by the project by providing further cash inflows from the project. A project having lower payback period is acceptable by the organization over the project having a longer payback period. The discounted payback period of the project is a period in which initial after-tax cash outflows of the organization can be paid by the project by providing further cash inflows from the project at their present value. A project having lower discounted payback period is acceptable by the organization over the project having longer discounted payback period.
An organization must have a positive net present value for accepting a project otherwise project is expected to provide loss. Additionally, internal rate of return of the project must be higher than the cost of capital of the organization so that difference between these two rates can be earned by the organization as income. Moreover, every organization is having some period after which organization needs to show profits from the project, discounted payback period of the organization’s project should be lower than the acceptable period from continuing with the project.
In the present case net present value of the Q power boat is $ 9,820,796.77. It is a positive net present value; hence from the perspective of net present value, this project is acceptable. Additionally, internal rate of return of the project is 58.50%; on the other hand, weighted average cost of capital of the organization is only 20% to 25%. Hence return rate is given by the project higher than the weighted average cost of capital of the organization, in this way; hence from the perspective of internal rate of return, this project is acceptable. Furthermore, the discounted payback period of the project is 2.14 years; however acceptable discounted payback period of the organization for every project is 4 years. In this way, a discounted period of the project is lower than the acceptable discounted payback period. Hence from the perspective of discounted payback period, this project is acceptable. Hence it can be concluded that all capital budgeting techniques’ are supporting the acceptance of Q powerboat project.
However, Q powerboat is having a qualitative characteristic which makes this project less effective. This product manufactured from this project is expected to do emission of carbon partials in water which results in water pollution and degradation. Due to this characteristic, this project can be demoted by environment protectors. In addition to this, this project is having declining expected revenue which also shows the effect of bad publicity on the organization’s productivity. Hence for this perspective, this project becomes unacceptable.
Calculation of net present value from operating flows of both project
|
Year |
Cash flows from Q power boat |
Present value |
|
|
Discount rate 20% |
Discount rate 25% |
||
|
1 |
$ 8,224,800.00 |
$ 6,854,000.00 |
$ 6,579,840.00 |
|
2 |
$ 7,594,800.00 |
$ 5,274,166.67 |
$ 4,860,672.00 |
|
3 |
$ 6,964,800.00 |
$ 4,030,555.56 |
$ 3,565,977.60 |
|
4 |
$ 6,334,800.00 |
$ 3,054,976.85 |
$ 2,594,734.08 |
|
5 |
$ 5,704,800.00 |
$ 2,292,631.17 |
$ 1,869,348.86 |
|
6 |
$ 5,074,800.00 |
$ 1,699,540.25 |
$ 1,330,328.37 |
|
Net present value |
$ 23,205,870.50 |
$ 20,800,900.92 |
|
|
Year |
Cash flows from S power boat |
Present value |
|
|
Discount rate 20% |
Discount rate 25% |
||
|
1 |
$ 6,400,000.00 |
$ 5,333,333.33 |
$ 5,120,000.00 |
|
2 |
$ 7,400,000.00 |
$ 5,138,888.89 |
$ 4,736,000.00 |
|
3 |
$ 7,900,000.00 |
$ 4,571,759.26 |
$ 4,044,800.00 |
|
4 |
$ 8,600,000.00 |
$ 4,147,376.54 |
$ 3,522,560.00 |
|
5 |
$ 9,300,000.00 |
$ 3,737,461.42 |
$ 3,047,424.00 |
|
6 |
$ 11,100,000.00 |
$ 3,717,367.54 |
$ 2,909,798.40 |
|
Net present value |
$ 26,646,186.99 |
$ 23,380,582.40 |
In the present case net present value is higher for S powerboat. Hence it can be concluded that all capital budgeting technique is supporting the acceptance of S powerboat project over Q powerboat.
Additionally, S powerboat is having a qualitative characteristic which makes this project more effective. This product manufactured from this project is does expected to do emission of carbon partials in water which results in an environmental safety. Due to this characteristic, this project can be promoted by environment protectors. In addition to this, this project is having increasing expected revenue which also shows the effect of good publicity of the organization’s produce. Hence for this perspective also S powerboat project is better over Q powerboat project.
S powerboat is expected to provide higher cash inflows from operations. Other cash flows both projects are similar hence those are non-considerable for the decision making. In addition to this, S powerboat project is environment-friendly.
Hence, the analysis made on the basis of various capital budgeting techniques and consideration of qualitative attribute of each project, it can be recommended that organization should continue with S powerboat project in place of Q powerboat project.
Abor, J. (2017). Evaluating Capital Investment Decisions: Capital Budgeting. Entrepreneurial Finance for MSMEs , 293-320.
Remer, D., & Nieto, A. (1995). A compendium and comparison of 25 project evaluation techniques. Part 1: Net present value and rate of return methods. International Journal of Production Economics , 42 (1), 79-96.
Rossi, M. (2015). The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice , 8 (1), 43-56.
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