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Quantitative Evaluation: Net Present Value

Decision making is one of the most vital parts of growth of an organisation. In order to ensure sustainability and growth it is necessary for the management to take correct decisions. Capital budgeting is the one of the most common and simple tools of decision making. The tools of capital budgeting helps the management to make decisions relating to capital investments. The investments made in these projects are huge and hence it is important to evaluate these projects in order to ensure profits for the organisation.

In the given case we have Leadall Corp, which is trying to evaluate an upcoming opportunity of making FP17, which is expected to generate profits for the company. In order to evaluate this project, we have used tools such as Net present value and discounted pay-back period to help us evaluate the feasibility of the project. (Goel, 2015)

Quantitative

Evaluating the Net Present Value of the Project

Net present value is one of the most commonly used tools of decision making. Under this system, the cash flows for a given project are estimated. These estimates are required to be made on various assumptions and keeping other factors in mind which could affect these cash flows. Theses cash flows are then summed together in order to arrive at the cash flows at the end of each year of the project (Peterson and Fabozzi, n.d.). These are then discounted using the appropriate and most suitable cost of capital. When the positive discounted cash flows are greater than the negative cash flows, the project is said to create value and considered viable. When the negative discounted cash flows are greater than positive discounted cash flows, the project is not considered viable and is rejected. (Shapiro, n.d.)

The Net Present Value Calculation of the Project has been shown below:

In the given case we see that the net present value of project FP17 results in positive $ 25,69,178, at the given cost of 20%. This means that company would earn $ 2.5 million in the period of five tears form the said project. Since the net present value is positive the project should be accepted.

Particulars

0

1

2

3

4

5

Initial Investment

 - Cost of Machinery

-70,00,000

 -

 -

 -

 -

 9,00,000

 - Working Capital Requirements

-5,00,000

 5,00,000

Operating transactions

Sale

 80,00,000

 72,00,000

 64,00,000

 56,00,000

 48,00,000

Variable Cost

 -40,00,000

 -36,00,000

 -32,00,000

 -28,00,000

 -24,00,000

Fixed Factory Overhead

 -1,50,000

 -1,50,000

 -1,50,000

 -1,50,000

 -1,50,000

Depreciation

 -10,50,000

 -10,50,000

 -10,50,000

 -10,50,000

 -10,50,000

Opportunity Cost

-15,000

-15,000

-15,000

-15,000

-15,000

Loss on Sale of Machinery

 -

 -

 -

 -

 -8,50,000

Net Income before tax

 27,85,000

 23,85,000

 19,85,000

 15,85,000

 3,35,000

Less : Income Tax @30%

 8,35,500

 7,15,500

 5,95,500

 4,75,500

 1,00,500

Profit after tax

 19,49,500

 16,69,500

 13,89,500

 11,09,500

 2,34,500

Add: Non cash expenses

 10,50,000

 10,50,000

 10,50,000

 10,50,000

 19,00,000

Operating Cash flow before tax

 38,35,000

 34,35,000

 30,35,000

 26,35,000

 22,35,000

Total Cash Flows from the project

-75,00,000

 38,35,000

 34,35,000

 30,35,000

 26,35,000

 36,35,000

 PV Factor @ 20%

1.000000

0.833333

0.694444

0.578704

0.482253

0.401878

Present Values of Net cash flows

-75,00,000

 31,95,833

 23,85,417

 17,56,366

 12,70,737

 14,60,825

NPV

 25,69,178

Notes:
 - The expenditure of $150000 is in the nature of sunk cost and has not been considered while making the decision.
 - assumed that no credit for import duty shall be available to the company. Hence total import duty and transportation cost has been made part of the cost of machinery.
 - the whole of working capital has been deemed to recovered at the end of project
 - The opportunity cost that has been lost has also been taken into consideration while taking the decision.
 - Normal rates has been charged for capital gain.

Calculation of Capital Gain/Loss

Book Value at the end of 5th year

 17,50,000

Less: Salvage

9,00,000

Capital Loss

8,50,000

Pay-back period is another tool of capital budgeting that helps to evaluate the project. Pay-back period can be defined as the period in which the investments made can be recovered by the company. There are two types of pay-back period, one is general pay back and the other is discounted pay back period. Pay-back period helps to calculate the time taken by the project to earn the investment made. The cash flows from the project after this period is the profit earned. Under the general pay-back period, normal cash flows are taken into consideration, whereas in the discounted pay back period, we take the discounted cash flows. (Clark, Hindelang and Pritchard, n.d.)

Qualitative Evaluation

In the given case we see that the management of Leadall Corp required the project to have a discounted pay-back of 4 years. See the table for discounted cash flows we see that the whole of the investments, made are recovered in the 4 year of the project. Therefore, the management requirement for the pay-back to be 4 years is satisfied. Therefore, taking the result of discounted pay back into consideration, we can say that the project can be accepted. (Dayananda, 2008)

Discounted Payback Period

 Year

 Cash flows

 Cumulative Cash flows

 -

-75,00,000

-75,00,000

1

31,95,833

-43,04,167

2

23,85,417

-19,18,750

3

17,56,366

-1,62,384

4

12,70,737

11,08,353

5

14,60,825

25,69,178

There are also qualitative factors which must be kept in mind before acceptance of the project. Few of these factors have been presented below:

  • Availability of funds:Capital budgeting projects require huge investments amount. It is important for the organisation to keep available the funds. Lack of financing during the execution of project may result in failure and loss to the organisation.
  • Working Capital Requirements: the projects require working capital investments. Working capitals serve as blood flow for the organisation. Lack of which may hamper the operating efficiency of the organisation.
  • Capital Return: the return expectations from these kinds of project are relatively higher. Economy is volatile and any factor may harm the project which may result in the failure of the project.(Herbst, n.d.)
  • Government Policies:the government policies affect the working of an organisation to a great effect. It is necessary for the management to look at the government policies related to the projected plan. It is important to have all the legal compliances be satisfied in order to carry the project without any obstacles.
  • Inapt Assumptions: Capital Budgeting decisions are required to be made based on a lot of assumptions. It is important to make these assumptions on solid ground based on available evidence. Use of inapt assumptions in the process of capital budgeting may result in wrong projection of the expected result.(Jacobs, 2008)
  • Issues in calculating the appropriate cost of capital: cost of capital is the most important quantitative figure which helps in the process of decision making. A wrong cost of capital may result in wrong projection of results. It is not necessary that the existing cost of capital would suit the project. The management may need to calculate a new rate in order to continue the project. Calculation of which is very tiring and a lengthy process.

Therefore, not only quantitative but the qualitative factors are also to be taken into consideration before accepting a project.

  • Decision as to accept or reject the project

As per our discussion above we see that the net present value for the said project is positive. Also the pay back requirement of pay-back period of the management has been satisfied by the given project (Capital Budgeting Valuation, 2013). Therefore, we can say that the project seems viable and the management should accept the project. This decision of acceptance of project is based on the quantitative analysis (Wilkes, n.d.).

  • Evaluating the expense made on Research & Development

The managing director of Leadall Corp wants to evaluate the expense made on research and Development by contributing form this project.  We need to comment on the viability of the project after 3% of its sales revenue is implemented in this ongoing R & D of the company.

We have calculated the net present value of the said project along with the discounted pay-back period, in order to determine the effect of this expense on the viability of this project. (Bedi, n.d.)

When we allocate the 3% of the sales revenue to the R & D expense we see that the net present value of the project falls from $25,69,178 to $ 25,09,178. The pay-back period is not much affected and remains approximately 4 years as required by the management. The NPV of the project still remains positive and hence viable for the company.

Therefore, we can say that the company is wants can take a part of contribution for the R & D form the sales revenues earned from FP17 project. The project would continue to be viable for the company and would earn those profits.

Particulars

0

1

2

3

4

5

Initial Investment

 - Cost of Machinery

 -70,00,000

-

 -

 -

 -

 9,00,000

 - Working Capital Requirements

 -5,00,000

 5,00,000

Operating transactions

Sale

80,00,000

 72,00,000

 64,00,000

 56,00,000

 48,00,000

Variable Cost

-40,00,000

 -36,00,000

 -32,00,000

 -28,00,000

 -24,00,000

Fixed Factory Overhead

-1,50,000

 -1,50,000

 -1,50,000

 -1,50,000

 -1,50,000

Depreciation

-10,50,000

 -10,50,000

 -10,50,000

 -10,50,000

 -10,50,000

Opportunity Cost

 -15,000

-15,000

-15,000

-15,000

-15,000

R & D Expense

 -24,000

-21,600

-19,200

-16,800

-14,400

Loss on Sale of Machinery

-

 -

 -

 -

 -8,50,000

Net Income before tax

27,61,000

 23,63,400

 19,65,800

 15,68,200

 3,20,600

Less : Income Tax @30%

8,28,300

 7,09,020

 5,89,740

 4,70,460

96,180

Profit after tax

19,32,700

 16,54,380

 13,76,060

 10,97,740

 2,24,420

Add: Non cash expenses

10,50,000

 10,50,000

 10,50,000

 10,50,000

 19,00,000

Operating Cash flow before tax

38,11,000

 34,13,400

 30,15,800

 26,18,200

 22,20,600

Total Cash Flows from the project

 -75,00,000

38,11,000

 34,13,400

 30,15,800

 26,18,200

 36,20,600

 PV Factor @ 20%

1.000000

 0.833333

0.694444

0.578704

0.482253

0.401878

Present Values of Net cash flows

 -75,00,000

31,75,833

 23,70,417

 17,45,255

 12,62,635

 14,55,038

NPV

 25,09,178

Discounted Payback Period

 Year

 Cash flows

 Cumulative Cash flows

 -

-75,00,000

-75,00,000

 1

31,75,833

-43,24,167

 2

23,70,417

-19,53,750

 3

17,45,255

-2,08,495

 4

12,62,635

10,54,140

 5

14,55,038

25,09,178

Conclusion

From the above discussion we can conclude that capital budgeting technique is one of the most useful techniques for decision making. Application of capital budgeting in the given scenario has helped us analyse that the project for the said product seems to generate positive value for the company and hence is viable. Therefore, we should accept the project.

References

Bedi, A. (n.d.). Capital budgeting. New Delhi: Deep & Deep Publications.

Capital Budgeting Valuation. (2013). Hoboken, N.J.: Wiley.

Clark, J., Hindelang, T. and Pritchard, R. (n.d.). Capital budgeting. Englewood Cliffs, N.J.: Prentice-Hall.

Dayananda, D. (2008). Capital budgeting. New York: Cambridge University Press.

Goel, S. (2015). Capital Budgeting. Business Expert Press.

Herbst, A. (n.d.). Capital budgeting. Cambridge, Angleterre: Harper & Row.

Jacobs, D. (2008). A review of capital budgeting practices. Washington, D.C.: International Monetary Fund, Fiscal Affairs Dept.

Peterson, P. and Fabozzi, F. (n.d.). Capital budgeting. New York: Wiley & Sons.

Shapiro, A. (n.d.). Capital budgeting and investment analysis. Upper Saddle River, NJ: Pearson/Prentice Hall.

Wilkes, F. (n.d.). Capital budgeting techniques. Chichester: John Wiley & Sons.

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