As per the case study which is given in the assignment, the management of Pinto Ltd is planning to invest in a project which will take the company in a new product market. The viability of the project needs to estimated for which the management has decided to conduct Capital Budgeting to establish whether investing in the project will benefit the business of Pinto ltd in the long run. The calculations for Capital Budgeting which would be including NPV analysis, profitability index, payback and discounted payback period analysis and IRR approach is shown in the appendix which is shown below.
The initial investment which the management estimates to be required in the projects is around $ 180,00,000. The initial investment is made up of investments in machinery which is shown in the calculations as $ 150,00,000 and the business will also be requiring additional working capital which is shown to be $ 30,00,000. The analysis is conducted for a period of five years as shown in the calculations. The management applies various techniques for estimating the worth of the project which are NPV, profitability, payback approach and discounted payback approach and IRR approach (Daskalakis 2013).
The purpose behind calculating the NPV of the project is to ensure that the project will be generating appropriate cash inflows which will be more than the cash outflows of the business (Cucchiella, D’Adamo and Gastaldi 2015). The NPV of the project as calculated is shown in appendix area which comes to about $ 54,72,272. The profitability index measures the profitability of the project in which the net cash inflows should be more than the cash outflows of the business. The profitability index of the business reveals that the company has a favorable profitability index which is shown to be 1.30 which is greater than 1. The profitability index establishes a relationship with the cash inflows of the business and cash outflows of the business. In the case of payback period, the calculation shows that the payback period comes to 2.73 years.
The payback period analysis shows the minimum time which the business takes for recovering the initial investments made by the business in the project (Wang, Xia and Zhang 2014). The method is useful as it provides the management the minimum time in which the management can recover the initial investments made by the same. The discounted payback period is an extension of payback period and the only difference between the two is that discounted payback period considers the cost of capital in the calculations. In addition to this, the method provides a clear idea as to how much time it will take to reach breakeven point of the project. The discounted payback period of the project is anticipated to be 3.38 years as shown in the calculations in the appendix section (Al-Alawi and Bradley 2013). Internal rate of return is the rate at which the cash inflows of the business is equal to the cash outflows of the business (Magni 2013). The IRR of the project as calculated is shown to be 20.94%.
The management in order to confirm whether to invest in the project or not have decided to apply uncertainty analysis which will be including scenario analysis and sensitivity analysis (Janssen 2013). The scenario analysis table is shown below:There are tow other approaches in a Scenario analysis which are optimistic approach and pessimistic approach which are discussed below:
- Optimistic Scenario: As per this scenario, it is assumed the selling price ill be growing at 4% and there will also be growth in sales volume in the first year and second year by about 70%. The business in such a scenario will be able to generate an NPV of $128,22,273 as shown in the above table.
- Pessimistic Scenario: As per this scenario. The growth in selling price is anticipated to be 2% and the growth in the sales volume of the business is shown to be 35% in the 1st and 2nd year as shown in the table. The NPV which can be generated under this approach is shown to be $ 14,39,907.
The sensitivity analysis shows that the changes which takes place in the NPV of the project when there is a small change in the cost of capital of the business which is taken at 10% for capital budgeting (Tian 2013). A table and a graph depicting sensitivity analysis is shown below:The above graph shows changes which takes place on NPV of the business when there is slight changes in the overall cost of capital of the business. The graph also shows that the NPV of the project becomes negative when the cost of capital increases to about 25%.
Findings and Recommendations
The above discussion makes it clear that Pinto ltd should invest in the project as the project seems to be profitable as per Capital budgeting analysis and uncertainty analysis (Burns and Walker 2015). The NPV of the project is shown to be positive and therefore favorable. The profitability index of the profit is greater than 1 which signifies that the project is definitely profitable. As the cost of capital is much less than IRR of the project, the investment in project is favorable. The sensitivity analysis also shows that if cost of capital is higher than 25% than 25% than the NPV will be negative which is not the case. The following recommendations can be suggested to Pinto ltd:
- The management needs to reduce the cost of operations so as to further increase the profitability of the business and recover the initial investment more quickly.
- The management needs to further maximize the sales following the Optimistic Scenario and aggressive sales strategy.
- The management needs to maintain a proper capital structure so that the cost of capital does not exceeds 25%.
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