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Capital Budgeting Analysis: Riverlook Packaging Inc

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Question:

Discuss about the Capital Budgeting Analysis for Riverlook Packaging Inc.

 

Answer:

Introduction 

Newlook Packaging Inc. is considering expansion of its current production capacity in order to supply innovative packaging to a pharmacy supermarket chain. For the purpose, the company will have to make long term investment in purchase of a machine and inventory. In return the project will generate additional revenues and also incur additional expenses like cost of sales, sales and administrative personnel expenses, opportunity cost of loss of rent, decrease in sales of existing products. Considering all of the above revenue and expenses, a capital budgeting analysis has been performed to advise the company on the acceptability of the project depending upon its profitability and required rate of return and the payback period.

In carrying out the analysis, certain assumptions have been made which are discussed below:

  • The cost of feasibility study is a sunk cost and hence has not been considered as an expense in the analysis
  • The increase in working capital is assumed to have been recovered in the last year of the project. Both inventory and net receivables.
  • Depreciation has been charged @ 14% on the total cost of machine which includes purchase price, transportation costs, warranty costs and installation costs.
  • After tax salvage value of the machine has been considered in year 6.
  • Tax benefit on opportunity cost of loss of rent on existing production lines, decrease in sales has been considered in the table of cash flows.
  • WACC @ 18% has been considered for discounting the cash flows. 

Capital Budgeting Analysis

Some of the prominent capital budgeting techniques were used in analysing the investment decision of the company which inclde Net present value, Internal rate of return, Profitability index and Payback period. On the basis of the results of these techniques, the final recommendation of wether to proceed with the project or not has been given.

NPV

NPV is the difference of present value of all cash inflows and the cash outflows. A positive NPV means the project will add value to the company to the amount of NPV (Titman, Martin, Keown, Martin, 2015)

NPV = $1,442,760

Discounted Payback Period

It is the number of years required to recover the initial investment by discounting the future cash flows

Year

Present value of cash flows

Cumulative cash flow

0

-$25,00,000.0

-$25,00,000.0

1

$8,12,033.9

-$16,87,966.1

2

$6,88,164.3

-$9,99,801.8

3

$5,83,190.1

-$4,16,611.7

4

$4,94,228.9

$77,617.2

5

$4,18,838.1

$4,96,455.3

6

$9,46,304.4

$14,42,759.7

 

 

Discounted payback period = 3.84 years

Profitability Index

PI is the ratio of sum of all discounted future cash flows to the initial investment.

PI = 3,942,760 / 2,500,000

   = 1.6

IRR

It is the discount rate at which the value of NPV is 0. An IRR greater than the discount rate is desired in a project.

IRR = 36% 

Recommendations 

Quantitative Factors

On the basis of the results of the above techniques, it is recommended that the company should go ahead with the project. The company requires a discounted payback period less than 4 years, the discounted payback period is 3.8 years which is less than 4, hence project becomes acceptable. The NPV of the project is positive. For a project to be acceptable, it is necessary for the NPV to be positive as positive NPV reflects profitability and the amount of NPV denotes the value added to the company. The PI should be more than 1 and it is 1.6 for the project. The IRR should be more than the discount rate; here the IRR is 36% which is more than 18%, thus making the project acceptable.

On assessing the viability of the project after contributing 2% of the sales revenue to the R&D, it was found that though the NPV remains positive but the discounted payback period increases to more than 4 years. And since the company requires a discounted payback period of less than 4 years, hence the company cannot go ahead with the project in this condition.

Qualitative Factors

The project is being opposed by consumer protection group as the packaging is 3D illusion which is very attractive for the children. However, in order to overcome this issue, the company should clearly mention the quality specifications of the product inside. This may save consumers from being mislead. After satisfying the consumer protection group, the company should go ahead with expansion of its production line.

Project Risks

One of the major risks in the project is estimation of the discount factor. The company has used its WACC as the discount rate. However, the company is producing a different type of packaging and hence the risks involved may be different from the company risk. Therefore, it is better to use a discount rate which completely incorporates the risks involved in this particular project (Drake, Ferguson, 2008) 

 

Reference 

Drake, P., Ferguson, G, (2008), Capital Budgeting and Risk, Investment Management and Finance Management, John Wiley & Sons, Wiley Online Library

Titman, S., Martin, T., Keown, A., Martin, J., (2015), Financial Management: Principles and Applications, 7th Edition, Pearson Australia

OR

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