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In the given scenario we see that the company Booli Ltd which has been involved in the production of electronic items wants to introduce in the market a new product. Introduction of a new project required detailed analysis and research on the same. (Seal, 2012)We have implemented a few capital budgeting techniques for the said proposal in order to evaluate the profitability of the same. Capital budgeting tool is a financial tool which helps us evaluate the viability of an investment option. (Adelaja, 2015)This is based on lot of assumptions and rules. It is important that all these rules are kept in mind while implanting this technique.
Pay-back period is the capital budgeting tool that helps the investor estimate the time period in which he would recover the invested amount in a project (Atkinson, 2012). The cash flows generated from a project after the pay-back period contribute towards the profit of the investor.
For the given case the pay-back period of the project is 2.02 years, with the project life of 5 years. This means that the project will recover the initial investment amount within 2.02 years and any earning beyond this will be profit for the company.
Profitability index is the return ratio which provides the investor with an estimated amount of return per unit of investment made by the investor. (Berry, 2009)The project of Booli ltd has a Profitability index of 1.71 times. This indicates that the project will earn 1.71 for every dollar invested. Since the amount earned is more than invested the project seems viable.
Internal rate of return calculate the actual return earned on project based on the estimated cash flows. (Bierman & Smidt, 2010) The internal rate of return of the for the project amounts to 37% percent, when the required rate of return for the project is 12%. Since the project is earning more than the expected rate the project seems financially viable.
Net present value is the sum total of present values of cash inflows and outflows. (Dayananda, Irons, Harrison, Herbohn, & Rowland, 2008) Positive NPV indicates creation of value and negation indicates loss. For the given project for Booli ltd the Net present value amount to $40.2 million. Since the project is expected to create value for the firm, it should be accepted.
The process of sensitivity analysis helps the investor evaluate the effect of change in independent variable on the dependent variables (Menifield, 2014). This process helps us calculate the variance in the expected result of the investment if any changes in the assumption for the investment are made. In our discussion following, we have discussed about the sensitivity of the project output with respect to change in the sales price and the units sold.
In our discussion below we have calculated the effect of change in price of the product on other outputs which have been discussed above.
We have increased the sale price of the product by 1% in order to evaluate the effect of change. Increase in sale price leads to increase in cash flows, which in turn increases the net present value. The net present value increased by 4.35%. The net present value earlier was $ 40.2 million; effect of increase in sale price increased the NPV to $ 41.9 million. Also, increase in sales price has the following effects:
The variable which was most affected by change in sales price is the net present value. Even a small change in the price of the product is likely to have a huge impact on the net present value of the proposed project.
In our discussion below we have calculated the effect of change in sales quantity of the product on other outputs which have been discussed above.
We have increased the sale quantity of the product by 1% in order to evaluate the effect of change. Increase in sale quantity leads to increase in cash flows, which in turn increases the net present value. The net present value increased by 2.23%. The net present value earlier was $ 40.2 million; effect of increase in sale quantity increased the NPV to $ 41.1 million. Also, increase in sales quantity has the following effects:
The variable which was most affected by change in sales quantity is the net present value. Even a small change in the quantity of the product is likely to have a huge impact on the net present value of the proposed project.
The figures used in capital budgeting decision are all based on detailed market research. The inputs and the outputs are pre determined based on assumptions and research. This not the actual data and in no way does this implicate that the result that will be achieved will be same as expected. (Noreen, 2015) This execution of capital budgeting technique is a risky work. Change in the inputs has a huge impact on the result of the investment. There is always an uncertainty risk involved in this execution. (Rivenbark, Vogt, & Marlowe, 2009) The project when analysed should be taken care of the uncertainties that are involved. The market is dynamic and the results may not turn out as expected. Therefore sensitivity analysis helps us have an idea of how these variables can affect the output.
There are certain costs which affect our decision of acceptance or rejection of investment proposal. The expenses which have already been occurred do not form part of capital budgeting decision as acceptance or rejection of the project will not affect the validity of the expenses already incurred (Peterson & Fabozzi, 2012). In case the investor has to let go any of his existing incomes due to acceptance of the project, then loss of such income should be included in the analysis.
In the given case Booli ltd might loose sales of existing product due to introduction of new product. This cost of this should be included in the analysis. This might reduce the returns from the new investment opportunity.
The calculations made above conclude that the project is likely to create positive wealth for Booli ltd. The project has a high net present value, with a good internal rate of return and low pay back period. The project seems viable form the financial perspective. The returns on the project are expected to be higher than the cost of the project.
Therefore, the project seems to create value for the company, and seems viable. Hence the project should be accepted.
Adelaja, T. (2015). Capital Budgeting: Investment Appraisal Techniques Under Certainty. Chicago: CreateSpace Independent Publishing Platform .
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.
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