Present Evaluating A Capital Budgeting †Myassignmenthelp.com

Question: Discuss about present evaluating a capital budgeting? Answer: Introduction A company named Equine Industries at present is evaluating a capital budgeting proposal which seeks to manufacture a horse feed which is high in protein. Various information about the key aspects of the project along with the expected incremental benefits and costs have been offered. In light of this information, the key objective of this report is to offer recommendation with regards to whether this project should be pursued further or not based on the application of relevant budgeting techniques particularly NPV (Net Present Value) and Payback Period. Analysis The given information in relation to determination of incremental project cash flows are indicated below. Cost of machine This would consist of not only the equipment cost but also the installation and transport cost (Damodaran, 2010). Hence total cost of machine at t=0 is $ 880,000 Depreciation Depreciation is charged on the asset at a straight line basis assuming a 10 year life of the equipment Hence annual depreciation = 880000/10 = $ 88,000 Disposal of machine At the end of the useful life of project of 5 years, the machine would be sold at $ 300,000 which would become the salvage value (Ross et. al., 2007). Book value of machine after five years = 880,000 (88000*5) = $440,000 Hence, loss on disposal of equipment = 440000 300000 = $ 140,000 Even though this is a non-cash charge, but it would reduce the tax liability and hence would be extended a treatment similar to depreciation (Titman et. al., 2016). Sunk Cost The cost of the market survey amounting to $ 35,000 would be sunk cost and hence not considered for the project evaluation as it is not an incremental cost (Brealey, Myers and Allen, 2012). Opportunity Cost The rent received by the warehouse till the last year amounted to $ 100,000 per year. Since the warehouse would be used in the project, hence an yearly cost of $ 100,000 would be the opportunity cost associated with the project and would be used for project evaluation (Damodaran, 2010). It is assumed that the working capital invested initially in the project would be recovered at the end of the useful life of the project which is at the end of five years. Also, the variable expenses are known to be 70% of the incremental revenues which are expected to increase by 10% on an annual basis. The WACC of the project is 12% while the applicable rate of tax is 30%. The incremental cashflow generated by the project based on the information discussed above and presented in the case is as indicated below (Titman et. al., 2016). Year 0 1 2 3 4 5 Incremental Revenues 1300000 1430000 1573000 1730300 1903330 (-) loss of revenues 200000 200000 200000 200000 200000 (-) Incremental manufacturing cost 910000 1001000 1101100 1211210 1332331 (+) Decrease in manufacturing cost 150000 150000 150000 150000 150000 (-) Cost of equipment 880000 (-) Depreciation 88000 88000 88000 88000 88000 (-) Training costs 45000 30000 (-) Investment in working capital 250000 (-) Loss of rent for warehouse 100000 100000 100000 100000 100000 (-) Loss on sale of equipment 140000 (+) Salvage Value 300000 (+) Recovery of working capital 250000 Cash flow before tax -1175000 122000 191000 233900 281090 742999 Tax @ 30% 0 36600 57300 70170 84327 222900 Cash flow post tax -1175000 85400 133700 163730 196763 520099 (+) Depreciation 88000 88000 88000 88000 88000 (+) Loss on sale of equipment 140000 Net cash flow post tax ($) -1,175,000 173,400 221,700 251,730 284,763 748,099 Based on the above incremental cashflows post-tax, the NPV of the project is as estimated below (Ross et. al., 2016). Year 0 1 2 3 4 5 Incremental Revenues 1300000 1430000 1573000 1730300 1903330 (-) loss of revenues 200000 200000 200000 200000 200000 (-) Incremental manufacturing cost 910000 1001000 1101100 1211210 1332331 (+) Decrease in manufacturing cost 150000 150000 150000 150000 150000 (-) Cost of equipment 880000 (-) Depreciation 88000 88000 88000 88000 88000 (-) Training costs 45000 30000 (-) Investment in working capital 250000 (-) Loss of rent for warehouse 100000 100000 100000 100000 100000 (-) Loss on sale of equipment 140000 (+) Salvage Value 300000 (+) Recovery of working capital 250000 Cash flow before tax -1175000 122000 191000 233900 281090 742999 Tax @ 30% 0 36600 57300 70170 84327 222900 Cash flow post tax -1175000 85400 133700 163730 196763 520099 (+) Depreciation 88000 88000 88000 88000 88000 (+) Loss on sale of equipment 140000 Net cash flow post tax -1175000 173400 221700 251730 284763 748099 PV factor (@ 12%) 1 0.89286 0.79719 0.71178 0.63552 0.56743 Present value of cash flows ($) -1175000 154821 176738 179176 180972 424492 NPV ($) -58,801 Also, as computed in the spreadsheet the payback period of the project comes out to be 4.33 years. Recommendation In accordance with the company policy, it is pivotal that the payback period must not be greater than 3 years. However, it is evident that the payback period for the current project is coming out to be more than the stipulated valued of 3 years that is sanctioned by the company. Further, since the payback period does not consider the time value of money, it is worthwhile to take the NPV or Net Present Value into consideration also since it is the most widely used measure in capital budgeting (Damodaran, 2010). The NPV for the project as indicated above is negative i.e. -$ 58,801. On account of the negative NPV and payback period of greater than 3 years, it may be fair to conclude that the given proceed is commercially not feasible and hence the company must not proceed with this project (Brealey,Myers and Allen, 2012). References Brealey, R.A., Myers, S.C. and Allen, F. (2012)Principles of corporate finance. 2nd edn. New York: McGraw-Hill Inc.,US. Damodaran, A. (2010)Applied corporate finance: A users manual. 3rd edn. New York: Wiley, John Sons. Ross, S.A., Trayler, R., Bird, R. and al, et (2007)Essentials of corporate finance. Sydney, Australia: McGraw-Hill Australia. Titman, S, Martin, T, Keown, AJ Martin, JD (2016), Financial management: principles and applications, 7th edn, Victoria: Pearson Australia