We have been provided with a new investment opportunity in which the company is required to take decision, if it should proceed with such opportunity or not. Booli Electronics is a company engaged in the business of manufacturing electronics. The company is seeking advice on introduction of new product. They have conducted a market analysis which has resulted in a collection of some financial data which might help us is taking the decision.
In order to evaluate the production opportunity, we have conducted capital budgeting for this project. The results of this tool will help us to take the correct decision. (Seal, 2012) The capita budgeting tool requires correct implementation and proper data in order to obtain the appropriate result but we should always keep in mind the uncertainties that come with new projects.
FINANCIAL VIABILITY OF THE PROJECT
Non-Discounted Pay-Back Period
Pay- back period is a capital budgeting tool that helps us calculate the estimated time within which the amount initially invested in the project will be recovered by the investors. (Rivenbark, Vogt, & Marlowe, 2009) The cash by the company in time of the project remaining after the pay- back period, will all be surplus. Therefore, lower the pay- back period the better it is.
For the given opportunity the pay- back period is 2.02 years, whereas the project will be carried on for 5 years. The pay- back period of the opportunity seems low.
Profitability index is the ratio that calculated the cash inflow flow per unit of initial cash outflow (Peterson & Fabozzi, 2012). Of the profitability index is more than one then it indicates profits, if equal to one then it means that only invested amount will be recorded and if less than one then it means that project will result in loss.
For the given project the profitability index is 1.71 time. The project will provide profits and hence should be accepted.
Internal Rate of Return
Internal rate of return will calculate the exact return on the project (Noreen, 2015). This rate is calculated by using the trial and error method on the expected cash inflows and outflows. If the internal rate of return is more than required rate of return then the project should be accepted.
The IRR for the given project results to be 37%. Therefore, the return on the investment is sufficient and the project should be accepted.
Net Present Value
Net present value calculates the difference between the cash inflows and cash outflows which are discounted using the required rate of return. (Menifield, 2014) If the net present value results in positive balance the project should be accepted.
The net present value of the given project results to be $ 40.2 million approximately. Since the project will result in positive NPV, it can be accepted.
Sensitivity analysis is the part of capital budgeting tool that helps us evaluate the effect of uncertainties on the results of the project. (Dayananda, Irons, Harrison, Herbohn, & Rowland, 2008) In this analysis the effect of change on input on the output is calculated.
Change in sales price
Change in sales price will change the cash inflows of the project which will in turn change the output. In order to quantify this change we have conducted the sensitivity analysis (Berry, 2009). We have changed the sales price by 1 percent in order to evaluate its affect on the net present value. We see that with one percent change in the sales price the net present value changes by 4.35%. We have also evaluated the change in sales price on other financial results:
- Impact on IRR- 1% increase in the price increased the IRR by 2.67%. As a result, IRR increased from 37% to 38%.
- Impact on pay-back period- 1% increase in the price decreased the pay-back period by 1.75%. As a result, pay-back period decreased from 2.02 years to 1.99 years.
- Impact on profitability index- 1 % increase in the price increased the profitability index by 1.77%. As a result, the profitability index increased from 1.71 times to 1.74 times.
We can observe from the calculations that the change in sales price has affected the Net present value majorly. It is clear that a small change in the percent of sales price has shown a significant change of the net present value.
Change in sales quantity
Change in sales quantity will change the cash inflows of the project which will in turn change the output. In order to quantify this change we have conducted the sensitivity analysis. (Atkinson, 2012) We have changed the sales quantity by 1 percent in order to evaluate its affect on the net present value. We see that with one percent change in the sales quantity the net present value changes by 2.23% . We have also evaluated the change in sales quantity on other financial results:
- Impact on IRR- 1% increase in the price increased the IRR by 1.30%. As a result, IRR increased from 37% to 37.47%.
- Impact on pay-back period- 1% increase in the price decreased the pay-back period by 0.94%. As a result, pay-back period decreased from 2.02 years to 2 years.
- Impact on profitability index- 1 % increase in the price increased the profitability index by 0.89%. As a result, the profitability index increased from 1.71 times to 1.73 times.
We can observe from the calculations that the change in sales price has affected the Net present value majorly. (Adelaja, 2015) It is clear that a small change in the percent of sales price has shown a significant change of the net present value.
The figures used while performing the capital budgeting is based on estimates and assumptions. Therefore, the expected return can never be equal to the actual return because of the changing assumptions and estimates.
EFFECT OF LOSS OF SALE OF OTHER MODELS DU%E TO NEW PROJECT
There are certain costs which are not to be included while carrying out the capital budgeting techniques. Similarly there are some costs which are to be included in the capital budgeting techniques in order to obtain appropriate results.
In case the company loses sales of its other products if it agrees to carry on this new project, then it would result in loss of sales. This loss will not take place if project is not accepted. Since the company will lose a part of profit in order to earn other, this coat will be classified as opportunity cost. (Bierman & Smidt, 2010) While taking the capital budgeting decision, we include the opportunity costs in analysis. Therefore, if the company loses sakes of its other product due to this ne product then, these costs will be included while evaluating the acceptability of this new project.
When a new project is being evaluated both the qualitative and quantitative factors are to be taken into consideration. The results of capital budgeting decision will always contain uncertainly due to assumptions made. Based on the results of the analysis above, we can see that the project will generate high returns for the investors. The production of new project will add high value to the firm. Based on this information we can say that the project seems financial viable and should be accepted.
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Atkinson, A. A. (2012). Management accounting. Upper Saddle River, N.J.: Paerson.
Berry, L. E. (2009). Management accounting demystified. New York: McGraw-Hill.
Bierman, H., & Smidt, S. (2010). The Capital Budgeting Decision. Boston: Routledge.
Dayananda, D., Irons, R., Harrison, S., Herbohn, J., & Rowland, P. (2008). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press.
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.
Seal, W. (2012). Management accounting. Maidenhead: McGraw-Hill Higher Education.