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## Capital Budgeting Analysis Methods

Discuss about the Plant Purchase, Installation and Replacement for Annual Worth.

The reason for the relevance of the annual worth, present worth and internal rate of return is in respect of capital budgeting decisions are as follows:

It is necessary to find the present worth of the company depending on the present value of the revenues to be generated by the company. It is because while calculating the present value of a future inflow several factors determine the rate of discounting to be used like the rate of interest, the rate of inflation present in the economy etc. The present value of the inflows gives an estimate regarding the real value that is going to flow into the entity (Demis et al., 2015).

The internal rate of return represents that the percentage of return that is generated from the proposed investment into the project. The internal rate of return is important for comparing with the cost of capital of the company. It might be possible that the Net Present Value of the project is positive but the rate of returns provided by it is not enough to beat the cost of capital of the company (Mizobuchi & Takeuchi, 2016). Hence, the value generated by the project will not be enough to meet the requirements of the entity in respect of repayment of the debt capital and to match the expectations of the shareholders of the company, in case IRR of the project is less than the Cost of Capital of the project.

The annual worth of the project or the inflows generated by the proposed project is very crucial for the management in case of the capital budgeting decisions. The reason behind this is that with the help of it the management of the company is able to objectively decipher the number of years after which it will be possible for the company to recover its invested amount. It is also called the discounting period of the project.

 Calculation of the Annual Worth of different Alternatives Particular A B C D Supply units 5000 5000 5000 5000 Sales price per unit \$3.00 \$3.00 \$3.00 \$3.00 Sales (1) \$15,000.00 \$15,000.00 \$15,000.00 \$15,000.00 Fixed Cost \$10,000.00 \$14,000.00 \$20,000.00 \$30,000.00 Capital Recovery Factor 0.22960738 0.22960738 0.22960738 0.22960738 (A/P,I,N) (2) \$2,296.07 \$3,214.50 \$4,592.15 \$6,888.22 Salvage value \$500.00 \$700.00 \$1,000.00 \$1,500.00 Sinking Fund factor 0.12960738 0.12960738 0.12960738 0.12960738 (A/F, i, N) (3) \$64.80 \$90.73 \$129.61 \$194.41 Annual Labor cost (4) \$9,000.00 \$7,500.00 \$5,000.00 \$3,000.00 Annual Power and maintenance cost (5) \$500.00 \$800.00 \$1,000.00 \$1,500.00 Annual Worth (1-2+3-4-5) \$3,268.73 \$3,576.22 \$4,537.46 \$3,806.19

The table above shows that the Annual worth of alternative C is the highest and Alternative A is the lowest.

 Calculation of the Present  Worth of different Alternatives Particular A B C D Sales \$15,000.00 \$15,000.00 \$15,000.00 \$15,000.00 Less: Annual Labor cost \$9,000.00 \$7,500.00 \$5,000.00 \$3,000.00 Annual Power and maintenance cost \$500.00 \$800.00 \$1,000.00 \$1,500.00 Depreciation \$1,583.33 \$2,216.67 \$3,166.67 \$4,750.00 Taxable Income \$3,916.67 \$4,483.33 \$5,833.33 \$5,750.00 Less: Tax Payment \$1,175.00 \$1,345.00 \$1,750.00 \$1,725.00 Net Income after tax \$2,741.67 \$3,138.33 \$4,083.33 \$4,025.00 Add: Depreciation \$1,583.33 \$2,216.67 \$3,166.67 \$4,750.00 Annual Cash inflow after tax \$4,325.00 \$5,355.00 \$7,250.00 \$8,775.00 Present value factor of Annuity 4.3553 4.3553 4.3553 4.3553 Present Value of cash inflow after tax \$18,836.50 \$23,322.42 \$31,575.64 \$38,217.41 Salvage Value \$500.00 \$700.00 \$1,000.00 \$1,500.00 Present value factor 0.56447393 0.56447393 0.56447393 0.56447393 Present value of salvage \$282.24 \$395.13 \$564.47 \$846.71 Fixed Cost (initial Investment) \$10,000.00 \$14,000.00 \$20,000.00 \$30,000.00 Present Worth \$9,118.74 \$9,717.55 \$12,140.11 \$9,064.12

The calculation above shows that the present value of alternative C is the highest and the present value of alternative D is the lowest.

 Calculation of IRR of different Alternatives Particular A B C D Year 0 -\$10,000.00 -\$14,000.00 -\$20,000.00 -\$30,000.00 Year 1 \$18,836.50 \$23,322.42 \$31,575.64 \$38,217.41 Year 2 \$18,836.50 \$23,322.42 \$31,575.64 \$38,217.41 Year 3 \$18,836.50 \$23,322.42 \$31,575.64 \$38,217.41 Year 4 \$18,836.50 \$23,322.42 \$31,575.64 \$38,217.41 Year 5 \$18,836.50 \$23,322.42 \$31,575.64 \$38,217.41 Year 6 \$19,336.50 \$24,022.42 \$32,575.64 \$39,717.41 Internal Rate of Return 188% 166% 157% 126%

The calculation above shows that IRR of alternative B is the highest. The lowest IRR is of the alternative D.

In case of the conventional benefit cost ratio, the numerator contains the net benefit that has accrued in respect of the user and the cost that has been incurred by the sponsor in the denominator. On the other hand, the modified Benefit Cost ratio undertakes to subtract the project operating costs and the maintenance cost of the project paid by the user from the net benefits that has accrued in respect of the users of the analysis (Shaw, 2015). The quantity thus received is all in the numerator. This leaves only the initial cost of the project in the denominator.

## Present Worth

It must however be noticed that though the math/ algebra used by the conventional benefit cost method and modified cost benefit are different, the resultant recommendation of both the method in respect of the acceptability of the projects would always remain same. In other words, the value of both the ratios will always range between greater than one to less than one for the same proposal (Walter & Risko, 2015).

These methods are used in the capital budgeting processes in order to conduct the cost benefit analysis. As in the numerator, the net income to be generated is recorded and in the denominator, the expenses to be incurred are being recorded, if the answer is greater than one then the benefits of the project are greater than the expenses and vice versa. Hence, depending on the value of the result obtained the project is accepted or rejected.

Conventional Benefit cost ratio value using Present worth method

 Calculation of Conventional B/C Ratio Value using Present Worth method Particulars Machine A Machine B Fixed Costs \$20,000.00 \$30,000.00 Salvage Value \$2,000.00 \$0.00 Annual receipt \$150,000.00 \$180,000.00 Annual Disbursement \$138,000.00 \$170,000.00 Present worth Factor of Annuity 6.144567106 6.144567106 Present worth Factor of Single payment 0.385543289 0.385543289 Present worth of benefit \$921,685.07 \$1,106,022.08 Present worth of annual disbursement \$847,950.26 \$1,044,576.41 Present value of salvage \$771.09 \$0.00 Initial Cost \$20,000.00 \$30,000.00 B/C Ratio value 1.06 1.03

Modified B/C Ratio value using Present worth benefit

 Calculation of Modified B/C Ratio Value using Present Worth method Particulars Machine A Machine B Fixed Costs \$20,000.00 \$30,000.00 Salvage Value \$2,000.00 \$0.00 Annual receipt \$150,000.00 \$180,000.00 Annual Disbursement \$138,000.00 \$170,000.00 Present worth Factor of Annuity 6.144567106 6.144567106 Present worth Factor of Single payment 0.385543289 0.385543289 Present worth of benefit \$921,685.07 \$1,106,022.08 Present worth of annual disbursement \$847,950.26 \$1,044,576.41 Present value of salvage \$771.09 \$0.00 Initial Cost \$20,000.00 \$30,000.00 B/C Ratio value 3.83 2.05
 Calculation of the After Tax Cash flow of the Leasing alternatives Particulars 1 2 3 4 5 6 7 8 9 10 Lease Cost 80000 60000 50000 50000 50000 50000 50000 50000 50000 50000 Other costs 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 Total Costs 84000 64000 54000 54000 54000 54000 54000 54000 54000 54000 Tax savings on expenses 25200 19200 16200 16200 16200 16200 16200 16200 16200 16200 After Tax Cash Flow 58800 44800 37800 37800 37800 37800 37800 37800 37800 37800
 Calculation of Equivalent Annual cost for the alternative (\$) Particulars 1 2 3 4 5 6 7 8 9 10 After Tax Cash Flow 56000 42000 35000 35000 35000 35000 35000 35000 35000 35000 PV factor 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665 0.4241 0.3855 PV of Cash flow 50909 34711 26296 23905 21732 19757 17961 16328 14843 13494 Net Present Value 239936 Annuity Factor 6.144567106 Equivalent Annual Leasing Costs 39048 Other costs 4000 Equivalent Annual Cost 43048
 Calculation of equivalent Annual cost of alternative options Particulars Keep X Replace X with Y Replace X with Z Initial Cost \$0.00 \$100,000.00 \$160,000.00 Annual Maintenance and Operating cost \$90,000.00 \$70,000.00 \$60,000.00 Salvage Value \$0.00 \$30,000.00 \$50,000.00 Pv Factor 0.3855433 0.385543289 0.385543289 PV of Salvage \$0.00 \$11,566.30 \$19,277.16 Net Initial Cost \$0.00 \$88,433.70 \$140,722.84 Annuity Factor 6.1445671 6.144567106 6.144567106 Equivalent Annual Cost \$90,000.00 \$84,392.18 \$82,901.99

The table above indicates the Equivalent Annual cost of different alternative options. It can be seen that the equivalent annual cost of replacing x with Z is low so this option should be selected.

The company under the study is ID Engineering Works Limited. The company is publicly listed and the deals extensively with civil engineering and civil works. The present report undertakes to develop an understanding regarding the concept and the tool called the Life Cycle Costing. Then the gaps that are present in the implementation of the same in the context of the present business must be understood (Stepanov et al., 2017). The understanding developed in respect of the gaps present within the system will enable their alleviation. After an understanding has been developed in this respect recommendation will be made to the management in terms of ensuring that the decision making process adopted by it should factor in the impact of the various costs associated with it.

Even after the contemplation about the successful implementation of the life cycle coting processes within the operational structure of the entity. Each application of any sort of accounting or management tool is accompanied by certain gaps. The gaps in the implementation of these tools and procedures arise due to several factors that are unique and sometimes redundant in case of related entity. In the present situation, too certain gaps have been identified in respect of the life cycle costing process implemented by the management of the company in respect of the actualisation of the life cycle costing framework (Mohammadirad & Nagasaka, 2015). It must be noted that the application of such system must not be eliminated by the management due to the reason that there are certain gaps present within the framework of the tool. Rather, the management should look forward towards filling up hot gaps effectively for the purpose of utilisation of the tool effectively and efficiently and create valuable source of information for itself thorough its application instead. The main purpose of identification of the gaps is thus, necessary for better implementation of the tool rather than providing the parameters to decide the validity of the same for the company. The gaps that have been discovered in the life cycle costing are as follows:

1. For referring to the nominal cash flows arising in respect of the entity, the management must make use of the nominal annual yield rates. In case the management decides to use the actual rates it must be ensured that, the cash flows are adjusted to the variations occurring in the price level index. In addition to that, the management must also factor in the effects of the expected annual inflation rate (Deo, 2016).
2. The costs must also be adjusted to the systematic risk that the fund provider is incurring. The reason for this is that every person providing funds to the entity expects appropriate and justifiable returns in respect of the risk that are being incurred by him.
3. The weights used by the management for the process must be based upon the market values of the wide range of financial resources used up by the management. In case of absence of information in this respect is absent the management must makes sure that it utilises the present accounting information available with itself (Azar et al., 2014).
4. The discount rate that is being used by the management for this purpose is always subject to change. The reason for the subjectivity of the changes of the discounting rates is due to many factors present within the business environment of the entity, which might be within or outside the control of the management (Di Dio et al., 2015). Some of the factors that are responsible for this include forecasted period of the cash flows, the alterations that might occur in the inflation rates, the presence of systematic risk and the present capital structure of the company.

## Internal Rate of Return

Recommendation in respect of improvement for cost/ benefit and risk management:

For the sustainability and the reliability of the operations of the assets owned by the company or the overall l operations conducted by the company it is necessary that the cost incurred by the entity and the returns generated in respect of them are continuously monitored by the management. In absence of the monitoring process the processes, tools and the control systems that are implemented by the management will go haywire in no time and will not be able to generate revenue and thereby failing to generate value for the stakeholders of the company at large (Oueslati et al., 2016). Some of the recommendation that is needed to be made for improving the cost/ benefit and the risk management of the company are as follows:

1. The management should ensure the adoption of the advanced tools, various techniques of analysis, various technologies for the purpose of optimising the management and conducting the planning, execution and control of the industrial production.
2. The management should ensure that the discounting rate that is being chosen by it factors in the various elements that are present in the environment of the entity. It must be able to clearly depict the effect of the various factors on the future cash flows of the company.
3. The weights that are identified by the management must be in accordance with the market values that the financial sources of the company bear (Bartela et al., 2014).

Conclusion:

From the above analysis, it can be concluded that the cost implications of the decisions taken up by the management has an immense bearing on the revenue to be generated by it in the future. And the returns that are going to be generated in respect of the stakeholders of the company as a result of the decisions that are used or taken up by the management. It is a well-known fact that the fixed assets owned by the company are the major sources of income that generate revenue for the entity in the end. Hence, the decisions regarding the acquisition of such assets form a significant part of the decisions of the management. Hence, the management must exercise caution and ensure that the right tolls are being used by it for determining the right decision in respect of acquisition, maintenance and the disposal of the assets of the company. In these decisions of the management, it is guided by the various managerial tools such as Life Cycle Costing.

Reference

Azar, R. T., Khalilarya, S., & Jafarmadar, S. (2014). Tube bundle replacement for segmental and helical shell and tube heat exchangers: experimental test and economic analysis. Applied Thermal Engineering, 62(2), 622-632.

Bartela, ?., Skorek-Osikowska, A., & Kotowicz, J. (2014). Economic analysis of a supercritical coal-fired CHP plant integrated with an absorption carbon capture installation. Energy, 64, 513-523.

Demis, S., Tapali, J. G., & Papadakis, V. G. (2015). Plant design and economics of rice husk ash exploitation as a pozzolanic material. Waste and Biomass Valorization, 6(5), 843-853.

Deo, P. (2016). Integration of Concentrated Solar Power Plant and Coal-Fired Power Plants for Block Size of 100 MW. In Renewable Energy in the Service of Mankind Vol II (pp. 731-739). Springer, Cham.

Di Dio, V., Favuzza, S., La Cascia, D., Massaro, F., & Zizzo, G. (2015). Critical assessment of support for the evolution of photovoltaics and feed-in tariff (s) in Italy. Sustainable Energy Technologies and Assessments, 9, 95-104.

Mizobuchi, K., & Takeuchi, K. (2016). Replacement or additional purchase: The impact of energy-efficient appliances on household electricity saving under public pressures. Energy Policy, 93, 137-148.

Mohammadirad, A., & Nagasaka, K. (2015, August). Modelling a 20MW scale solar farm in an unused angled area near fukushima nuclear power plant. In Advanced Mechatronic Systems (ICAMechS), 2015 International Conference on (pp. 194-199). IEEE.

Oueslati, H., Mabrouk, S. B., Mabrouk, A. B., La Cascia, D., Zizzo, G., Dusonchet, L., ... & Massaro, F. (2016, June). Feasibility analysis and study of a grid-connected hybrid electric system: Application in the building sector. In Environment and Electrical Engineering (EEEIC), 2016 IEEE 16th International Conference on (pp. 1-6). IEEE.

Shaw, T. L. (2015). Fuel Switch to Biomass for the Continued Use of an Otherwise Stranded Coal Fired Steam Electric Asset.

Stepanov, S., Solkina, O., Stepanov, A., & Zhukova, M. (2017, October). Waste water biological purification plants of dairy products industry and energy management. In IOP Conference Series: Earth and Environmental Science (Vol. 90, No. 1, p. 012097). IOP Publishing.

Walter, J. P., & Risko, J. R. (2015). Successful Implementation of a Sustainable Steam Trap Management Program. In Energy Management and Efficiency for the Process Industries(pp. 164-178). John Wiley & Sons, Inc..

Yoshino, H., Uemura, T., Sugitani, K., & Fujimoto, N. (2016). U.S. Patent No. 9,408,146. Washington, DC: U.S. Patent and Trademark Office.

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