Capital Budgeting Analysis of Replacing Existing Product

Question: Discuss about the Capital Budgeting Analysis of Replacing Existing Product. Answer: Introduction Capital Budgeting is the process of determining the profitability of an investment in order to maximize returns on investment. Various techniques are used to decide whether a particular investment should be undertaken. Some of these techniques include NPV, IRR, profitability index, payback period. Depending on the decision rule for the above techniques, an investment project is accepted or rejected. (Peterson, Fabozzi, 2004) Cash Flow Analysis Runwell Corporation is planning to introduce a new line of vehicle parts which will be environment friendly as carbon emission will be reduced. However, the new project will require renovation of an existing section of the factory. The project will have a life of eight years as it is expected that the technological up gradation of the manufacturing process will render the production line obsolete in 10 years. There are various expenditures which the company will have to undertake immediately in order to start the production line like purchase of plant equipment, increase in working capital, renovation of the existing part of the factory. Apart from the initial investment, the project will have annual expenditures related to the project. However, the revenue will start flowing only from the first year. Hence, in order to decide whether to invest in the project or not, a capital budgeting analysis has been carried out which will determine of the project is viable and profitable or not . A cash flow table presenting the various cash inflows and outflows for the project period of 8 years is presented below: Cash Flow 0 1 2 3 4 5 6 7 8 No. of boxed sold 48000 48000 48000 48000 48000 48000 48000 48000 Selling price $30 $30 $30 $30 $30 $30 $30 $30 Sales Revenue $14,40,000 $14,40,000 $14,40,000 $14,40,000 $14,40,000 $14,40,000 $14,40,000 $14,40,000 Variable cost $7,20,000 $7,20,000 $7,20,000 $7,20,000 $6,48,000 $6,48,000 $6,48,000 $6,48,000 Fixed cost $1,60,000 $1,60,000 $1,60,000 $1,60,000 $1,60,000 $1,60,000 $1,60,000 $1,60,000 Opportunity cost of rent $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 Quality assurance inspection $36,000 $36,000 $36,000 $36,000 $36,000 $36,000 $36,000 $36,000 Training expense $18,000 Total Operating cost $9,64,000 $9,46,000 $9,46,000 $9,46,000 $8,74,000 $8,74,000 $8,74,000 $8,74,000 Depreciation $1,30,000 $1,30,000 $1,30,000 $1,30,000 $1,30,000 $1,30,000 $1,30,000 $1,30,000 Net Income $3,46,000 $3,64,000 $3,64,000 $3,64,000 $4,36,000 $4,36,000 $4,36,000 $4,36,000 Tax @30% $1,03,800 $1,09,200 $1,09,200 $1,09,200 $1,30,800 $1,30,800 $1,30,800 $1,30,800 Profit after tax $2,42,200 $2,54,800 $2,54,800 $2,54,800 $3,05,200 $3,05,200 $3,05,200 $3,05,200 Operating cash flow after tax $3,72,200 $3,84,800 $3,84,800 $3,84,800 $4,35,200 $4,35,200 $4,35,200 $4,35,200 Initial Investment $16,67,000 Terminal Value $2,92,000 Net Cash flow -$16,67,000 $3,72,200 $3,84,800 $3,84,800 $3,84,800 $4,35,200 $4,35,200 $4,35,200 $7,27,200 Discount factor@14% 1 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 Present value of cash flows -$16,67,000 $3,26,491 $2,96,091 $2,59,729 $2,27,832 $2,26,029 $1,98,271 $1,73,922 $2,54,927 NPV NPV = $2, 96,293.08 Discounted payback period Year PV of cash flows Cumulative discounted cash flows 0 -$16,67,000 -$16,67,000 1 $3,26,419 -$13,40,581 2 $2,95,911 -$10,44,669 3 $2,59,740 -$7,84,929 4 $2,27,802 -$5,57,128 5 $2,25,869 -$3,31,259 6 $1,98,451 -$1,32,808 7 $1,74,080 $41,272 8 $2,55,247 $2,96,519 Discounted payback period = 6.8 years Working Notes Initial Investment Initial Investment Cost of PE $14,00,000 Renovation cost $1,30,000 Transportation cost $40,000 HR cost $48,000 Increase in working capital $49,000 Total Investment $16,67,000 Depreciation Cost of PE $14,00,000 Transportation costs $40,000 Installation costs $70,000 Total cost of PE $15,10,000 Salvage value $2,10,000 Depreciable amount $13,00,000 Depreciation per annum $1,30,000 Terminal Value Terminal Value Proceeds from sale $2,50,000 Cost of sales $24,000 Net Proceeds $2,26,000 book value of PE $4,70,000 Loss on sale $2,20,000 Tax benefit on loss on sale $66,000 After tax proceeds from sale $2,92,000 Recommendation The project has a positive NPV of $2, 96,293.08.On the basis of the NPV, the project is viable as the present value of future cash flows is more than the cash outflow and the project will give a profit of more than 2 lakhs. Moreover, the company has an option to sell the contract to another company for $200,000. Since the NPV is more than the amount receivable on selling the contract, it is more profitable to introduce the new line of vehicle parts. The company has a required discounted payback period of 5 years. However, the project has a discounted period of 6.8 years which means the company will not be able to recover the original investment before the 6th year. On the basis of the required discounted payback period, the project cannot be accepted. Hence, the company should sell the contract to another company for $200,000. Risk Analysis A company needs to discount its future cash flows in a capital budgeting analysis. The discount rate used to discount such cash flows is a very important phenomenon as a small mistake in selecting the appropriate discount rate may result in huge differences in the analysis results. Hence, it is important to select a discount rate which accounts for the risk of the project. WACC of a company is considered to be the ideal discount rate for projects having risks similar to that of the existing business of the company. WACC is the minimum required rate of return for the investors. It is a sum of the cost of equity and cost of debt of a company. The capital structure of a company consists of debt and equity. Hence, a rate of return which accounts for both the sources of finance is the cost of capital. WACC is ideal for investment proposals with similar business risks like an investment proposal of a cloth trader to open a new store in a new location. Here since the business risk is the same; it is advisable to take WACC as the discount rate. However, for the current project proposal, WACC is not the ideal discount rate because the project has a risk higher than the normal course of business. The project is a technology driven one where the new production line will produce vehicle parts that will be environment friendly and reduce carbon emission. However, in a competitive world where technology seems to be ever changing, it is expected that the production process will become obsolete and hence the project will have to be closed. The risk of the technology up-gradation is very high and as such it is important to account for the higher risk in the discount factor. If the technology up-gradation takes place before the expected period of eight years, then the company will have to immediately stop the new production process as the vehicle part will no longer be saleable. A higher discount rate will ensure that higher cash flows are generated in order to recover the initial investment in the project life as with higher discoun t rate the present values will decrease and as such higher cash flows will be required to recover investment. The discount factor will have to be increased. An increase in the discount factor will lead to a reduction in the present value of cash flows and as such the NPV of the project will decrease. (Landier, Thesmar, Kruger, 2011) With WACC as the discount rate, the project has a discounted payback period of more than 5 years, so with an increase in the discount rate, the discounted payback period will further increase and the NPV will fall making the project unacceptable. References Peterson, P., Fabozzi, F.J, (2004), Capital Budgeting : Theory and Practice, Wiley Finance Kruger, P., Landier, A., Thesmar, D., (2011), The WACC Fallacy: The Real Effects of Using a Unique Discount Rate