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Pay- Back Period

Discuss about the Business Finance for Investment Appraisal Techniques Under Certainty.
 

Whenever we are provided we a new investment opportunity, we try to makes sure that this opportunity will turn out to be profitable with us. (Adelaja, 2015) There are various analysis and studied conducted in order to evaluate the output of the said opportunity. Similarly, when a company is to engage in the production of a new product, then such situation is similar to new investment opportunity.

We are provided with data of Booli Ltd. the company is evaluating the production of a new product. We have conducted a thorough capital budgeting analysis of the said proposal in order to determine if this will be a profitable opportunity for the company or not. Details of such analysis have been mentioned below.

Given below are few of tools which will help us evaluate the financial profitability of the new proposal of Booli Ltd.

Pay- back period is the tool of capital budgeting that helps the investor calculates the recovery time of the initially invested amount in the project. Lower the pay- back period, better the project is considered. The pay- back period this is calculated using discounted cash flows is the discounted pay- back period, and the one which is calculated using normal cash flows is called non- discounted cash flows. (Atkinson, 2012)

The pay- back period of the new proposal of the company is 2.02 years. The project life is for 5 years. This means that the company will have almost 3 years in order to generate profits.

Profitability index is the capital budgeting tool or ratio that helps calculate the return per unit of investment. This is calculated by dividing the present value of cash inflows by the cash outflows. Higher the ratio better it is. (Berry, 2009)

The profitability index for the company is 1.71 times. The investor is expected to earn $1.71 for $1 invested in the new proposal. This gives the investor a margin of $0.71 on every dollar invested. 

The internal rate of return is that tool of capital budgeting which helps the investor calculate the actual return from the cash inflows of the new proposal. This is calculated by equating the cash inflows and cash outflows. The hidden rate which equates them is the internal rate of return. The project is generally accepted when the internal rate of return is higher than the discount rate. (Bierman & Smidt, 2010)

Profitability index

The internal rate of return for the proposal of the company is 37%. This is higher than the discount rate of 12%. This indicates high profitability from the new proposal.

Net present value is the tool that helps calculate the present value of net cash inflows of the said investment strategy. It is the most commonly use feature of capital budgeting analysis. If the Net present value is positive the project is considered, if it is negative then it is not to be accepted. (Dayananda, Irons, Harrison, Herbohn, & Rowland, 2008)

The net present value of the new proposal amounts to $ 40.2 million. This project is expected to create positive net present values, and hence seems viable.

Sensitivity analysis is a part of capital budgeting analysis that helps the investor calculates the effect of deviations in the input variables on the result of the project. (Kuti, 2014) Due to uncertainties involved the output from the project may change, sensitivity analysis helps analyse these variances.

We have calculated the effect of change in price of the product on the result of the new project. Increasing the sale price of the new product by 1% will increase the cash inflows, which will in turn increase the net present value. The one percent increase in the sale price resulted in 4.35% increase in net present value. The net present value increased to $ 41.9 million from 40.2 million. We have also, calculated the effect of this increase on pay-back period, profitability index and internal rate of return:

  • IRR increases form 37% to 38% with one percent increase in sales price
  • Profitability index increases from 1.71 times to 1.74 time with one percent increase in sales price
  • Pay- back period decreases from 02 years to 1.99 years with one percent increase in sales price

Therefore we see that the net present value of the project is most sensitive to change in sale price of the product.

We have calculated the effect of change in quantity of the product on the result of the new project. Increasing the sale quantity of the new product by 1% will increase the cash inflows, which will in turn increase the net present value. The one percent increase in the sale quantity resulted in 2.23% increase in net present value. The net present value increased to $ 41.1 million from $40.2 million. We have also, calculated the effect of this increase on pay-back period, profitability index and internal rate of return:

  • IRR increases form 37% to 37.48% with one percent increase in sales quantity
  • Profitability index increases from 1.71 times to 1.73 time with one percent increase in sales quantity
  • Pay- back period decreases from 02 years to 2 years with one percent increase in sales quantity

Therefore we see that the net present value of the project is most sensitive to change in sale quantity of the product.

Capital budgeting analysis is a detailed investigation into the cash flows of the project. These cash flows are calculated based on market survey and studies. Any change in the market conditions will have impact on the result of the project. (Lerner, 2009) The result of the project is very sensitive to any change in the assumptions. This creates risk of uncertainty in the project. The discount rate that is used in the evaluation of the project should also be chosen based on lot of study. This is a very relevant factor. Any wrong assumption or lack of use of any small information may have a huge impact on this discount rate. The discount rate should be calculated based on all of the qualitative and quantitative data. The capital budgeting analysis will always have a risk that pertains to uncertainty and also of wrong rate being used in evaluation of the project. It is important the investor takes into consideration the impact of all this risk that might affect the result of the project. (Menifield, 2014)

Internal Rate of Return

The cost in decision making may be classified into many categories. The major two categories in which these costs can be classified are relevant cost and irrelevant cost. (Noreen, 2015) Relevant cost are those cost which are to be included while evaluating the decision of investment proposal acceptance. Irrelevant costs are those cost which do not affect the decision making of an enterprise (Peterson & Fabozzi, 2012). Opportunity costs are kind of relevant cost. Opportunity cost is the cost which the company incurs due to acceptance of the new project.

In the given case the company is proposing to sell a new electronic item which will be technologically advanced. Introduction of this product may lead to loss of sales of the other products of the company. (Rivenbark, Vogt, & Marlowe, 2009)Loss of revenue for existing products due to new project is a kind of opportunity cost and is relevant in decision making process. Therefore, the loss of revenue due to acceptance of new project is to be considered as cost and is to be included while evaluating the financial viability of this new proposal.

Conclusion And Recommendation

Taking all the data and information provided above we can see that the project is expected to generate profits for the company. The introduction of new project is likely to create profits up to $40.2 million in the period of 5 years. The project has a low pay- back period of 2.02 years and a high internal rate of return of up to 37%. The financial output of the project is very good. This is the quantitative analysis. All other qualitative data should also be taken into account before the final decision is taken. (Seal, 2012)

Based on the current information the project and the evaluation of financial data, we recommend that the production of new product 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.

Kuti, M. (2014). Crowdfunding: How to Fund Your Business Idea. Retrieved from www.business.gov.au: https://www.business.gov.au/info/run/finance-and-accounting/finance/crowdfunding-how-to-fund-your-business-idea

Lerner, J. J. (2009). Schaum's outline of principles of accounting. New York: Schaum.

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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