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Capital Budgeting Techniques
1: Part a) i. Net Present Value
Investment 1

Year

 Cash Inflows

 Cash Outflows

 Net Cash Flows

 Pvf @12.50%

 Present Value Of Cashflows

0

 $

-  

$

46,00,000.00

 $

-46,00,000.00

1.000

$

-46,00,000.00

1

$

16,00,000.00

$

6,00,000.00

 $

10,00,000.00

0.889

$

8,88,888.89

2

 $ 

20,00,000.00

 $

 5,00,000.00

 $          15,00,000.00

0.790

$

11,85,185.19

3

 $   24,00,000.00

 $          6,00,000.00

 $          18,00,000.00

0.702

 $   12,64,197.53

4

 $   22,00,000.00

 $          8,00,000.00

 $          14,00,000.00

0.624

 $     8,74,013.11

5

 $   18,00,000.00

 $        10,00,000.00

 $            8,00,000.00

0.555

 $     4,43,943.17

 NPV

 

 

 

 

 $     56,227.88

Investment 2

Years

 Cash Inflows

 Cash Outflows

 Net Cash Flows

 Pvf

 Present Values

0

 $                        -   

 $        40,00,000.00

 $        -40,00,000.00

1.000

 $  -40,00,000.00

1

$

14,00,000.00

$

6,00,000.00

$

8,00,000.00

0.889

$

7,11,111.11

2

$

18,00,000.00

$

5,00,000.00

$

13,00,000.00

0.790

$

10,27,160.49

3

 $   22,00,000.00

 $          6,00,000.00

 $          16,00,000.00

0.702

 $    11,23,731.14

4

 $   20,00,000.00

 $          8,00,000.00

 $          12,00,000.00

0.624

 $      7,49,154.09

5

 $   16,00,000.00

 $        10,00,000.00

 $            6,00,000.00

0.555

 $      3,32,957.37

 NPV

 

 

 

 

$     -55885.79

ii. Internal Rate Of Return
Investment 1

Trial Runs Table

Net Cash Flows

 PVF@13%

 PV

 

 PVF @13.5%

 PV

 $       -46,00,000.00

 $     1.000

 $ -46,00,000.00

 

1.000

 $ -46,00,000.00

 $         10,00,000.00

 $     0.885

 $     8,84,955.75

 

0.881

 $     8,81,057.27

 $         15,00,000.00

 $     0.783

 $   11,74,720.03

 

0.776

 $   11,64,392.87

 $         18,00,000.00

 $     0.693

 $   12,47,490.29

 

0.684

 $   12,31,076.16

 $         14,00,000.00

 $     0.613

 $     8,58,646.22

 

0.603

 $     8,43,615.58

 $           8,00,000.00

 $     0.543

 $     4,34,207.95

 

0.531

 $     4,24,727.79

 

 

 $                 20.24

 

 

 $       -55,130.34

IRR Formula= Lower Rate +   NPV at Lower Rate / NPV at Lower Rate- NPV at Upper Rate X (Upper Rate – Lower Rate)

= 0.13 + 20.24 /20.24+55130.34 x  (0.1350-0.13) = 13% Approximately                           

Investment 2

Trial Runs Table

Net Cash Flows

 PVF@12%

 PV

 

 PVF @11%

 PV

$ -40,00,000.00

1.000

 $-40,00,000.00

 

1.000

 $-40,00,000.00

$ 8,00,000.00

0.893

$ 7,14,285.71

 

0.901

$ 7,20,720.72

 $ 13,00,000.00

0.797

 $ 10,36,352.04

 

0.812

$ 10,55,109.16

 $ 16,00,000.00

0.712

$ 11,38,848.40

 

0.731

$ 11,69,906.21

 $ 12,00,000.00

0.636

$ 7,62,621.69

 

0.659

$ 7,90,477.17

$ 6,00,000.00

0.567

$ 3,40,456.11

 

0.593

$ 3,56,070.80

 

 

 $ -7,436.04

 

 

$ 92,284.06

IRR Formula = 0.13+ 7436.04/ 92284.06+7436.04 x (0.12-0.11) = 11.92% Approximately                    

iii. Payback Period
Investment 1

Table for discounted payback period

Years

 Net Cash Flows

 Pvf

 Present Value Of Cashflows

 Cumulative Pv Of Cashflows

0

$

-46,00,000.00

1.000

$

-46,00,000.00

$

-46,00,000.00

1

$

10,00,000.00

0.889

 $

8,88,888.89

$

-37,11,111.11

2

$

15,00,000.00

0.790

$

11,85,185.19

$

-25,25,925.93

3

$

18,00,000.00

0.702

$

2,64,197.53

$

-12,61,728.40

4

$

14,00,000.00

0.624

 $

8,74,013.11

$

-3,87,715.29

5

$

8,00,000.00

0.555

$

4,43,943.17

$

56,227.88

 

 

 

Payback Period

4.87 years

Payback period =4 + -3, 87,715.29/4, 43,943.17 = 4.87 Years 

Investment 2

Note: As the NPV of the Investment 2 is negative, it would not have any Payback period as the cost of the initial investment would not be recovered during the entire project life. 

iv. Annual Rate Of Return
ARR = Average net income after depreciation and taxes/Initial investment
Investment 1

Year

Cash Inflows

 

Cash Outflows

 

Net Cash Flows

 

Depreeciation

 Net Earnings

0

 $

-   

$

46,00,000.00

 $

-46,00,000.00

 $

$

-46,00,000.00

1

$

16,00,000.00

$

6,00,000.00

$

10,00,000.00

$

9,20,000.00

$

19,20,000.00

2

$

20,00,000.00

$

5,00,000.00

$

15,00,000.00

$

9,20,000.00

$

24,20,000.00

3

$

24,00,000.00

$

6,00,000.00

$

18,00,000.00

$

9,20,000.00

$

27,20,000.00

4

$

22,00,000.00

$

8,00,000.00

$

14,00,000.00

$

9,20,000.00

$

23,20,000.00

5

$

18,00,000.00

$

10,00,000.00

$

8,00,000.00

$

9,20,000.00

$

17,20,000.00

 
Depreciation =    Cost of Asset/Life of Project   =   $   46, 00,000.00/5 =   $ 9, 20,000.00                     

Average net income of 5 Years =   $ 111, 00,000.00/5 =   $ 22, 20,000.00 

ARR = $ 22, 20,000.00/ 46, 00,000.00  = 48%

Investment 2

Cash Inflows

 Cash Outflows

 

Net Cash Flows

 

Depreciation

 Net Income

 $                        -   

$

40,00,000.00

$

-40,00,000.00

0

$

-40,00,000.00

 $   14,00,000.00

 $

 6,00,000.00

$

8,00,000.00

$

8,00,000.00

 $

16,00,000.00

$

18,00,000.00

$

5,00,000.00

$

13,00,000.00

$

8,00,000.00

$

21,00,000.00

$

22,00,000.00

$

6,00,000.00

 $

16,00,000.00

$

8,00,000.00

$

24,00,000.00

$

20,00,000.00

$

8,00,000.00

$

12,00,000.00

$

8,00,000.00

$

20,00,000.00

$

16,00,000.00

$

10,00,000.00

$

6,00,000.00

$

8,00,000.00

$

14,00,000.00

Recommendations:

NPV of Investment 2 is negative hence it should not be made rather investment 1 should be made as it as positive NPV.

IRR of capital investment 2 is less than the cost of capital hence it should not be undertaken rather investment 1 should be made as it has higher IRR than the cost of capital.

Investment 2 cannot recover its initial cost of investment during its life and hence it must be ignored and the investment 1 should be opted as it will recover the cost in 4.87 years.

ARR of investment 1 is higher than that of investment 2 and hence investment 1 is better

Part b)

Sensitivity analysis is an important technique of capital budgeting which is used to evaluate the risk involved in any investment (project) plan. It helps the managers by providing the necessary information to take sound economic benefits ((Baker & English, 2011). This analysis involves the calculations to understand the impact of changes in the project’s input parameters on the particular project. Since the cash flows of Noothercompany Limited are fluctuating over the five years, it involves higher risk due to uncertainty of cash flows every year. Hence sensitivity analysis must be undertaken as a part of capital investment decision making process in the present case. Following variables should be sensitised this case:

  • Life of project
  • Cost of capital
  • Initial investment

Since, with the change in the above mentioned input parameters the NPV of the project will also be changed, therefore the degree of sensitivity of project’s NPV will have to be checked to assess the risk involved in the project. Therefore, sensitivity analysis must be undertaken for these variables. 

2. Part a)
Return On Investment = Net Profit / Cost of Investment x 100
                                                              

 

Queensland (QLD)

New South Wales  (NSW)

Net Profit (A)

$

2,20,000.00

$

4,50,000.00

Cost of Investment (B)

 $

10,00,000.00

$

25,00,000.00

ROI       [ (A/B)*100]

22%

18%

 
Depreciation = $ 4000000/ 5 = $800000 

Average net income of 5 Years =   $ 9500000/5  =   $ 19000000

ARR = $ 19000000/ 4000000 = 47.5%
Analysis: Since the division QLD is generating higher return on investment than that of division NSW, it can be said that it performing better than NSW.

Note: Investments are the only operating assets available in the question.

b) Residual Income =  Net Operating Income-(Required Rate Of Return x  Operating Assets) 

 

 

QLD

NSW

Net Operating Income

 (A)

$          2,20,000.00

$            4,50,000.00

Required Rate of Return

 (B)

13%

13%

Operating Assets

 ( C)

$        10,00,000.00

$          25,00,000.00

 RI         [A –( B * C)]

 

$ 90,000

$ 1,25,000

 
Since the division NSW is having higher residual income left i.e. it is providing higher income left after desired income (minimum required return), therefore it can be said that is performing well.
Part b)

Residual income measures offers more accurate results than the return on investment measures as RI measures returns in dollars whereas ROI measures results in percentage.

Therefore, the manager should rely on the results of RI measures and select Division New South Wales for the further investment as it will generate higher income.

Part C) Residual Income
Strengths:
  • It provides flexibility since it allow use of different cost of capital for the investments that have differed risk characteristics.
  • Residual income
  • Residual income increases in the cases where investment that earns more than cost of capital selected and investments that earns less than the cost of capital are ignored.
Weaknesses:
  • It does not offer comparison between the investment centres when level of investments is different for all the centres.
  • It does not also relate the size investment centre’s income with the investment. 
Return on investment
Strengths:
  • It serves as benchmark to measure the efficiency of investment or operating assets and enables the business managers to understand and emphasise on the relationship between sales, expenses an investments.
  • It aids managers in making comparison of several business divisions in profitability and asset utilisation terms (Bierman & Smidt, 2012). 
Weaknesses:
  • It can lead to making dysfunctional decisions that impacts the efficient asset allocation.
  • The information of sales, costs, assets etc. is difficult to be obtained at times.
  • Economic value added is the measure used to evaluate the financial performance of the company on the basis of its residual wealth. It is calculated by deducting firm’s cost of capital from its net operating profits after taxes.

There is no benefit of using EVA in place of RI in this case as they are similar measures with the difference that the EVA measure considers operating profits after taxation effect. In this question there is no tax rate given so use of EVA would not make any difference.

3. Part a) i. Profit & Loss Budget of Last Chance Group Limited 

 

 year 1

 year 2

 year 3

 year 4

 year 5

 Sales (A)

$

45,00,000.00

65,00,000.00

$

85,00,000.00

$

65,00,000.00

$

45,00,000.00

 Cost Of Sales (B)

$

15,75,000.00

$

22,75,000.00

$

29,75,000.00

$

22,75,000.00

$

15,75,000.00

 Gross Profit C= (A)-(B)

$

29,25,000.00

$

42,25,000.00

$

55,25,000.00

$

42,25,000.00

$

29,25,000.00

Less: Admin & Selling Expenses:

 

 

 

 

 

 Rent  (D)

$

3,00,000.00

$

3,00,000.00

$

3,00,000.00

$

3,00,000.00

$

3,00,000.00

Repairs & Maintenance (E)

 $   1,00,000.00

 $     1,00,000.00

 $   2,00,000.00

 $    2,00,000.00

 $   3,00,000.00

S & A Salaries (F)

$

4,00,000.00

4,20,000.00

$

4,41,000.00

$

4,63,050.00

$

4,86,202.50

Profit Before Depreciation (C-D-E-F)

$

21,25,000.00

$

34,05,000.00

 $

45,84,000.00

$

32,61,950.00

$

18,38,797.50

Less: Depreciation

 $ 27,50,000.00

 $   20,62,500.00

 $15,46,875.00

 $  11,60,156.25

 $   8,70,117.19

Profit Before Interest And Tax/Operating Profit

 $ -6,25,000.00

 $   13,42,500.00

 $30,37,125.00

 $  21,01,793.75

 $   9,68,680.31

ii. Cash Flows For Five Years

 

 year 1

 year 2

 year 3

 year 4

 year 5

Operating Profit (from above table)

$

-6,25,000.00

$

13,42,500.00

$

30,37,125.00

$

21,01,793.75

$

9,68,680.31

Add: Depreciation

$

27,50,000.00

$

20,62,500.00

$

15,46,875.00

$

11,60,156.25

8,70,117.19

Cash Flows Per Annum

$ 21,25,000.00

$  34,05,000.00

$

45,84,000.00

$ 32,61,950.00

$

18,38,797.50

Application Of Discounted Cash Flows Techniques

NPV Application

 

Year 0

 year 1

 year 2

 year 3

 year 4

 year 5

cash flows per annum

 $-110,00,000.00

 $   21,25,000.00

 $  34,05,000.00

 $45,84,000.00

 $ 32,61,950.00

 $    18,38,797.50

PVF  @ 13%

1

0.885

0.783

0.693

0.613

0.543

Present values

 $

-110,00,000.00

$  18,80,530.97

 $  26,66,614.46

$

31,76,941.94

$

20,00,615.02

$

9,98,025.61

NPV (Sum of PVs of Year 0 to Year 5)

$

-2,77,271.99

 

 

 

 

 

Analysis: Since the NPV of the project is negative it must not be accepted.

IRR Application

Trial Run Table:

PVF @ 12%

1.000

0.893

0.797

0.712

0.636

0.567

 cash flows per annum

 $

-110,00,000.00

$  21,25,000.00

$ 34,05,000.00

$

45,84,000.00

$ 32,61,950.00

$ 18,38,797.50

 PV

 $

-110,00,000.00

 $   18,97,321.43

 $  27,14,445.15

 $32,62,800.66

 $ 20,73,028.20

 $    10,43,383.08

 NPV

 $          -9,021.48

 

 

 

 

 

PCF @ 11%

1.000

0.901

0.812

0.731

0.659

0.593

 cash flows per annum

 $

-110,00,000.00

$  21,25,000.00

 $  34,05,000.00

 $45,84,000.00

 $ 32,61,950.00

 $    18,38,797.50

 PV

 $-110,00,000.00

 $   19,14,414.41

 $  27,63,574.39

 $33,51,781.29

 $ 21,48,747.50

 $    10,91,236.82

 NPV

 $       2,69,754.41

 

 

 

 

 

IRR Formula= 0.11+  269754.41 / 269754.41+9021.48 x (0.12-0.11) = 11.97% Approximately

Analysis: Since the IRR is lower than the required rate of return of 13%, the project must not be undertaken

Part b)

Budgeting is the integral part of future planning. It has its own advantages and advantages that are given below:

Advantages:
  • It provides businesses with the ‘’plan of spending ’’ and thereby helps the managers in decision making.
  • It provides the tool to evaluate the performance of company by offering the basis to make comparisons of actual and planned results.
  • It aids the distribution and appropriate allocation of resources of the business to the key areas (DRURY, 2013).
Disadvantages:
  • Budgeting process is featured by rigidity of Budgeted plans which do not work in the changing environment of business (Wampler, 2010).
  • It is also very time consuming process.
References:

Baker, H. K., & English, P. (2011). Capital budgeting valuation: Financial analysis for today's investment projects (Vol. 13). John Wiley & Sons.

Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.

DRURY, C. M. (2013). Management and cost accounting. Springer.

Wampler, B. (2010). Participatory budgeting in Brazil: Contestation, cooperation, and accountability. Penn State Press.

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