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Relevant and Non-Relevant Costs of the Proposed Project

What Is The Capital Budgeting Practices Of The Fortune?

This report is being prepared to analyze the decision of Safa Motors Ltd in regards to the replacement of old plant and equipment that is currently being used in the manufacturing of petrol and diesel cars with the new plant that will manufacture the electrical vehicles. If the new plant is implemented then the production of petrol and diesel car be abandoned and hence the old plant and equipment will run out of use and hence it will be disposed in the market and funds from it will be used to acquire the new machine that is more technical in nature. Since the investment in new plant requires huge amount of funds, such replacement decision must be carefully evaluated by applying various techniques of capital budgeting such as net present value analysis, payback period analysis, sensitivity analysis .etc. The incremental cash flows approach has been used to evaluate the replacement decision.

While determining the worthiness of any project, the project manager has to undertake the cost benefit analysis of the project under which all the costs and benefits of the project are separately and jointly considered to understand their impact on the overall value of the project. Primarily, the cost is divided into two categories i.e. the relevant cost and irrelevant cost. Relevant costs are those costs that are useful to be given consideration while taking the decisions about project’s acceptance or rejection. However relevant costs are those costs that do not affect the further cash flows of the project and are the common part of all the alternative projects under considerations. These costs are either sunk costs that have already been incurred or the costs that forms part in all the alternative options of investment.

In the present case, the cost of research carried for the diesel and petrol cars is a sunk cost as it has already been incurred and hence it cannot be recovered under any circumstance. Therefore this cost of £250000 is irrelevant in nature and thus it must be ignored while making the evaluation of equipment decision. Further, the cost of acquisition of old equipment used to manufacture the petrol and diesel cars is not to be taken into consideration while making the calculation of incremental initial investment as it has already been incurred. But, the same must be considered to calculate the depreciation on the equipment. However, the depreciation expense on both the equipment is also irrelevant in nature since the present question has asked to ignore the tax impact of the cash flows and hence the depreciation is not relevant to be considered in such as it does not amount to flow of cash (Chen, 2008). The relevant costs of the replacement decision under consideration are all other costs that are taken into consideration while calculating the net present value of the project. These costs are: Cost of acquisition of new investment, material cost, labor cost, variable cost, fixed cost such as research and development cost, selling , savings in the cost of components of old car, increase in the cost of new components.

The Total Cash Flows and Profits for the Next Five Years

The total cash flows and the profits for the next five years under both the projects i.e. manufacturing the old cars only and the new cars only are shown in the tables below:

Refer Appendix 1:

Year

1

2

3

4

5

Profit

 £    36,470,000.00

 £    36,470,000.00

 £    36,470,000.00

 £    36,470,000.00

 £    36,470,000.00

Year

0

1

2

3

4

5

Free Cash Flows

 £                                                                                                          -   

 £    37,750,000.00

 £    37,750,000.00

 £    37,750,000.00

 £    37,750,000.00

 £    37,800,000.00

Year

0

1

2

3

4

5

Profit

-£                                                                                    9,996,500.00

 £    17,575,262.00

 £    35,970,262.00

 £    43,212,112.00

 £    50,818,217.50

 £    58,806,856.17

Year

0

1

2

3

4

5

Free Cash Flows

-£                                                                                    9,996,500.00

 £    19,414,562.00

 £    37,809,562.00

 £    45,051,412.00

 £    52,657,517.50

 £    61,446,156.17

Refer Appendix 2

Year

 0

1

2

3

4

5

Incremental Profit

-£    18,894,738.00

-£          499,738.00

 £       6,742,112.00

 £    14,348,217.50

 £    22,336,856.17

The cash flows under new project are accounted for by taking into consideration the savings in the component cost of old machinery and increase in the component cost of new machinery on the assumption that such savings and costs will take place in each year.

Further, the cost volume analysis is undertaken to determine the impact of cost and volume factor of the outcomes on the overall profitability of the project. Breakeven analysis is the analysis under which, sales at the point at which the company does not incur any loss or earn any profit, is calculated. It is the point at which the project is able to cover all its cost with the revenues. The sales quantum beyond the breakeven point is called as margin of safety. From the CVP analysis, it has been found that, in order to reach at the point where the company incurs no loss and earns no profit, it is required to sell 43723 units of new electric vehicles and after this point it will start earning profits (Refer Appendix 3).

Further in the report various techniques of capital budgeting are applied to evaluate the replacement decision. For this purpose, NPV, IRR, ARR and Payback Period are calculated. The NPV of the replacement decision is positive and hence it indicates that it will be profitable to accept the decision of manufacturing the electric vehicles only in place of diesel cars. However, the desirable payback period of the project is 3.5 years while the calculations have shown that the old machinery replacement will result in the payback period of around 4.34 years which is higher than the desirable period of time (Refer Appendix 4). Therefore, it is necessary to identify the objective of company behind such investment. If the company is expecting to earn maximum returns within the minimum time then it must not accept the proposed project. But, if the main aim of the project is to earn maximum returns irrespective of the time period it must accept the new plant implementation project as the calculation of Annual rate of return is found to be quite higher (85%) than the desirable results (35%). Further, the internal rate of return of the project is 15.17% and it is higher than the cost of capital of the project (12%). It signifies that the project has higher return potential. Therefore it must be accepted.

Total Incremental (Net) Profits and Cash Flows

Further, the sensitivity analysis is applied to understand the project’s sensitivity in terms of NPV is undertaken using various variables (Graham & Harvey, 2002).The impact of change in such variables on the overall NPV of the project is analyzed as below:

(Refer Appendix 5)

Change in sales volume

Increase in sales units by 10%

 £  325,452,353.62

Decrease in sales units by 10%

 £  145,522,441.60

Change in selling price

Increase in Selling Price by 10%

 £  570,244,836.75

Decrease in Selling Price by 10%

-£ 466,790,151.65

Change in required rate of return

Increase in Required rate of return by 2%

 £             27,346.68

Decrease in Required rate of return by 2%

 £       3,765,287.37

Change in useful life of project

Increase in years in useful life by 1 year

 £    37,178,243.96

Decrease in years in useful life by 1 year

-£    11,648,946.61

Each technique of investment appraisal has some of its strengths and also each of these techniques suffers from limitations that are discussed below:

The payback period technique of capital budgeting is used to determine the time that the project will take to recover funds invested in the project. It is basically the break-even point of the investment. The project that has the potential to recoup its cost of investment in minimum time is acceptable. The technique of pay- back period has its own strengths and limitations which are as follows:

  • The determination of payback period is comparatively easier than other techniques of capital budgeting and hence it can conveniently be applied to the project.
  • It is most significant for the firms that have limited resources as it determines the project that is capable of generating returns quickly. Payback period is the most appropriate technique for the projects that have low investment budget.
  • Payback period helps the project manager to identify the risk of the project even before the commencement of the same by indicating the time within which the project will recoup the project cost.
  • This technique is also best suitable to the industries where there are trends of technical obsolesce because of the short spans of such projects (Baker & English, 2011).
  • The technique of payback period does not consider the time value of money and it counts as the significant weakness of this technique.
  • Moreover, payback period takes into consideration the annual cash flows and not the net income of the project. The consideration of net profits offers more realistic results than the cash flows of the project and due to this reason, the realistic results are not offered by payback period.
  • Also, the terminal value of the project is also considered in the payback technique.
  • The cash flows that are supposed to be generated after the payback period are not considered under payback technique and therefore it fails to take the overall view of the project’s riskiness.

The net present value technique of the project is the most common technique of capital budgeting. It involves determination of the overall worth of the project on the basis of total present value of net cash flows of the project (Hall & Millard, 2010). Under this technique, all the inflows and outflows of project are considered and then the net impact of such cash flows is calculated to determine whether the project has the potential to generate returns or it will result in net cash outflows. Advantages: 

  • The key strength of the project is that it considers the cash flows of the project over the entire useful life of the project.
  • Further, the technique of net present value gives regards to the time value of money and hence it gives more realistic picture of project returns and risks.
  • The interpretation of the results of net present value technique is easier to be understood than the results of other techniques.
  • The calculation of net present values of the project requires the determination of required rate of return i.e. the cost of capital so as to calculate the present values of the cash flows.
  • The projects with different life spans are tough to be evaluated under this technique as the comparison is not possible (Kahraman, 2001).

 ARR is the only technique of capital budgeting that uses the net profits to determine the financial feasibility of the project and not the cash flows associated with the project. Each project has its own pre determined cut off rate and if the ARR of such project is higher than the cut off rate then it is acceptable because it has the ability to generate returns (Ryan & Ryan, 2002). The key strengths and limitations of accounting rate of returns are:

  • This technique involves convenient approach of determining the project’s worth.
  • As the net profitability of the project is considered to evaluate its worthiness under ARR method, the results of it are more sophisticated in nature (Peterson & Fabozzi, 2002).
  • The time value of money is not considered under ARR technique also and hence the results of this technique are not accurate enough.
  • It also ignores the reduction in the value of original investment in the way it charges depreciation against the profits reported by it. The theory of recovery of capital over a time period is ignored under ARR (Borgonovo, 2017).
  • Further the application of ARR is irrelevant under the situations where capital investment is not undertaken at the commencement stage of project.

It is the rate at which there does not arise any profits and loss under the project and hence the NPV of the project is zero at the IRR point. The reason why there is no profit or loss at this point is that the present value of cash inflows is equals to the present value of cash outflows (Baker, Jabbouri & Dyaz, 2017). The strengths and limitations of IRR technique are discussed below:

  • The importance of time value of money is given due consideration under IRR technique.
  • All the cash flows of the project are taken into account under this method and hence it offers more reliable results.
  • The objective of wealth maximization of the owner is met under IRR method of capital budgeting analysis (Verbeeten, 2006).
  • The final outcomes of this technique are complex in nature and hence not easily understandable.
  • IRR involves the application of hit and trial method to reach at the final internal rate of return (Truong, Partington & Peat, 2008).

All the above techniques that are discussed above are used to determine the financial feasibility of the project but in order to accept the replacement decision, it is also necessary to consider non financial factors of the proposed project.

Cost Volume Profit Analysis

The non-financial factors are those factors that would not be affecting the project’s performance in monetary value but will influence the decision of the project manager (Bennouna, Meredith & Marchant, 2010). These factors are:

  • Competition and Market Structure:

Before deciding on the replacement of the old vehicle manufacturing machines with the new machines it is necessary to identify the major competitive forces of the industry so as to decide whether the proposed project will result in creation of monopoly, oligopoly or monopolistic competition market structure in the country.

  • Technology, labor and raw material availability:

The manufacturing of new electric vehicles will require deployment of advanced technology and highly skilled labor force. Also, whether the raw material required for producing the electric cars will be available in the domestic market or it will be required to import from different countries. Therefore, it is necessary to consider the availability of such requisites of new manufacturing unit in the market before taking up the replacement decision.

  • Environmental impact:

Before replacing the old vehicle manufacturing plant and equipment it must be ensured that the proposed new manufacturing plant and equipment will meet the environmental regulations and standards of the country as one of the major reasons behind the decline in the demands of diesel and petrol vehicles is the emission of toxic elements from such vehicles in the environment that causes heavy pollution.

  • Specific features of electric cars:

Since the electric vehicles requires the electric charging that involves considerable time therefore the people will not adopt the change in the technology easily and this factor will affect the replacement decision to a material extent.

Conclusion:

From the overall financial analysis, it has been found that the project of replacing the old vehicle manufacturing car with the new plant that produces electric vehicles is quite sensitive in nature to various input variables and hence all such variables must be taken into due consideration before reaching the final solution. Further, it is also important for Safa Motors Ltd. to consider the non-financial factors also that are associated with the replacement decision. The application of capital budgeting techniques has shown that the proposed replacement project will take more substantial period of time to cover the initial costs of investment and hence it is recommended that the company must continue with the manufacturing of diesel cars. However, if the firm has an objective of maximum return generation then it must accept the new machinery investment decision as it will entail positive NPV and higher ARR than the expected results.

References:

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

Baker, H.K., Jabbouri, I. and Dyaz, C. (2017). Corporate finance practices in Morocco. Managerial Finance, 43(8), 865-880.

Bennouna, K., Meredith, G.G. and Marchant, T., 2010. Improved capital budgeting decision making: evidence from Canada. Management decision, 48(2), pp.225-247.

Bierman Jr, H. and Smidt, S. (2014) Advanced capital budgeting: Refinements in the economic analysis of investment projects. Oxon: Routledge.

Borgonovo, E. (2017). Sensitivity Analysis: An Introduction for the Management Scientist (Vol. 251). Switzerland: Springer.

Brigham, E. F., & Houston, J. F. (2012). Fundamentals of financial management. Cengage Learning.

Brijlal, P., 2008. The use of capital budgeting techniques in businesses: A perspective from the Western Cape. Available at: < https://repository.uwc.ac.za/bitstream/handle/10566/3786/Brijlal_The-use-of-capital_2009.pdf?sequence=1&isAllowed=y>v Accessed on: 27.7.2018

Chen, S., 2008. DCF techniques and nonfinancial measures in capital budgeting: a contingency approach analysis. Behavioral Research in Accounting, 20(1), pp.13-29.

Daunfeldt, S.O. and Hartwig, F. (2014). What determines the use of capital budgeting methods?: Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4),101-112.

Dayananda, D., Harrison, S., Irons, R., Herbohn, J. and Rowland, P., 2002. Capital budgeting: financial appraisal of investment projects. Cambridge University Press.

Drake, (n.d.) Capital Budgeting Decisions. Available on: < https://educ.jmu.edu/~drakepp/principles/module6/capbudtech.pdf> Accessed on: 27.07.2018.

Graham, J. and Harvey, C., 2002. How do CFOs make capital budgeting and capital structure decisions?. Journal of applied corporate finance, 15(1), pp.8-23.

Hall, J. and Millard, S., 2010. Capital budgeting practices used by selected listed South African firms. South African Journal of Economic and Management Sciences, 13(1), pp.85-97.

Kahraman, C., 2001. Capital budgeting techniques using discounted fuzzy cash flows. In Soft Computing for Risk Evaluation and Management (pp. 375-396). Physica, Heidelberg.

Peterson, P.P. and Fabozzi, F.J., 2002. Capital budgeting: theory and practice (Vol. 10). John Wiley & Sons.

Ryan, P.A. and Ryan, G.P., 2002. Capital budgeting practices of the Fortune 1000: how have things changed. Journal of business and management, 8(4), pp.355-364.

Truong, G., Partington, G. and Peat, M., 2008. Cost-of-capital estimation and capital-budgeting practice in Australia. Australian journal of management, 33(1), pp.95-121.

Verbeeten, F.H., 2006. Do organizations adopt sophisticated capital budgeting practices to deal with uncertainty in the investment decision?: A research note. Management accounting research, 17(1), pp.106-120.

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