Techniques Include Payback Period - Discounted Payback Period

Question: Discuss Capital Budgeting is A Process Used By the Companies ? Answer: Introduction Capital budgeting is a process used by the companies to evaluate investments which are long term in nature. Under the process, the various income and expenses related to the project are analysed to arrive at a conclusion as to whether or not the project should be undertaken. There are various techniques which can be used in capital budgeting. The most important of them all includes Net present value (NPV) which is the excess of cash inflows to cash outflows. If the NPV of the project is negative, the project is out rightly rejected. Other techniques include payback period, discounted payback period, internal rate of return and profitability index (Drake, NA) Investment Evaluation Runwell Corporation is considering a proposal to introduce a new line of vehicle parts which is more environments friendly and helps in reducing carbon emission. However, the proposal requires investment in new plant and machinery, renovation of an existing part of the factory, and other personnel expenses. The project is expected to continue for eight years after which the up gradation of technology will make the production line obsolete. An analysis of the various income and expenses was carried out and a cash flow table was prepared to calculate the net present value of the project and also the discounted payback period which should be less than 5 years. The analysis is presented below: Year 0 1 2 3 4 5 6 7 8 No. of boxes sold 48000 48000 48000 48000 60000 60000 60000 60000 Selling price $30 $30 $30 $30 $30 $30 $30 $30 Revenue $14,40,000 $14,40,000 $14,40,000 $14,40,000 $18,00,000 $18,00,000 $18,00,000 $18,00,000 Variable costs $7,20,000 $7,20,000 $7,20,000 $7,20,000 $8,10,000 $8,10,000 $8,10,000 $8,10,000 Fixed costs $1,60,000 $1,60,000 $1,60,000 $1,60,000 $1,60,000 $1,60,000 $1,60,000 $1,60,000 Quality assurance inspection charges $36,000 $36,000 $36,000 $36,000 $36,000 $36,000 $36,000 $36,000 Training expense $18,000 Opportunity cost $2,500 $2,500 $2,500 $2,500 $2,500 $2,500 $2,500 $2,500 Depreciation $1,64,000 $1,64,000 $1,64,000 $1,64,000 $1,64,000 $1,64,000 $1,64,000 $1,64,000 Operating income $3,39,500 $3,57,500 $3,57,500 $3,57,500 $6,27,500 $6,27,500 $6,27,500 $6,27,500 Taxes @ 30% $1,01,850 $1,07,250 $1,07,250 $1,07,250 $1,88,250 $1,88,250 $1,88,250 $1,88,250 Income after tax $2,37,650 $2,50,250 $2,50,250 $2,50,250 $4,39,250 $4,39,250 $4,39,250 $4,39,250 Cash flows from operating income $4,01,650 $4,14,250 $4,14,250 $4,14,250 $6,03,250 $6,03,250 $6,03,250 $6,03,250 Terminal value $3,05,600 Initial investment -$17,63,000 Net cash flows -$17,63,000 $4,01,650 $4,14,250 $4,14,250 $4,14,250 $6,03,250 $6,03,250 $6,03,250 $9,08,850 Cost of capital @14% $1 $0.877 $0.769 $0.675 $0.592 $0.519 $0.456 $0.400 $0.351 Present value of cash flows -$17,63,000 $3,52,325 $3,18,752 $2,79,607 $2,45,269 $3,13,309 $2,74,833 $2,41,081 $3,18,606 NPV = $5, 80,781.2 Discounted Payback period Year Present value of cash flows Cumulative cash flows 0 -$17,63,000 -$17,63,000 1 $3,52,325 -$14,10,675 2 $3,18,752 -$10,91,924 3 $2,79,607 -$8,12,317 4 $2,45,269 -$5,67,047 5 $3,13,309 -$2,53,738 6 $2,74,833 $21,094 7 $2,41,081 $2,62,176 8 $3,18,606 $5,80,781 Discounted payback period = 5.9 years Working Notes 1) Initial Investment Initial investment Renovation cost $1,30,000 Procurement of human resources $48,000 PE cost $14,00,000 Transportation cost $40,000 Installation cost $70,000 Employee training cost $26,000 Increase in working capital $49,000 Initial investment $17,63,000 2) Depreciation Depreciation Renovation cost $1,30,000 PE cost $14,00,000 Transportation cost $40,000 Installation cost $70,000 Total cost $16,40,000 Depreciation $1,64,000 3) Terminal Value Terminal value Sale of machine $2,50,000 cost of sale $24,000 Net sale value $2,26,000 Book value of machine $3,28,000 Loss on sale $1,02,000 Tax on loss $30,600 After tax sale value $2,56,600 Recovery of working capital $49,000 Terminal value $3,05,600 In calculating the after tax sale value of the plant and equipment, there is loss on sale of PE as the book value is more than the market value. Hence, there would be tax benefit on the loss. This will increase the net sale proceeds. Recommendation On the basis of the above analysis and the value of the NPV, the project looks profitable as the NPV is positive and means that the income from the project is more than the project expenses. However, the GM of the company requires a discounted payback period of 5 years, however the discounted payback period the project is more than 5 years i.e. 5.9 years, hence the project cannot be accepted. The company has the option to sell the contract to another compliant company for $200,000. Had it not been for the risk of the project of the technology getting obsolete, the company would not have restricted its discounted payback period to 5 years and would have gone ahead with the project because the value of NPV is $580,781 which is more than $200,000. This would have been more profitable, but since the payback period is more than 5 years, the company will have to sell the contract to another company for $200,000. WACC as the discount factor Weighted average cost of capital is the average rate of return which the investors of the company expect. WACC represents the risk of the total capital of the company (Fernandez, 2011). It is used as a discount factor to discount the cash flows into the present in order to calculate the NPV. Most of the companies use WACC as the discount factor for an investment evaluation. However, it is not the most appropriate rate when it comes to evaluating a project which is different from the current business of the company (Jacobs, Shivdasani, 2012) In the present case also, the company is introducing a new line of business, hence it is better to use the WACC of that particular industry to which the product belongs to. This will ensure that the risks associated with the particular product are incorporated in the WACC. Discount rate is a very sensitive factor in capital budgeting and minimal change in discount rate may result in huge difference in the result of the proposal (Neufville, Clark, Field, NA). Hence, it is recommended that the appropriate discount rate which encompasses the risk of the project should be taken into consideration. Conclusion The new investment proposal of Runwell Corporation has a positive outcome in terms of profitability. The profits are more than what the company could earn by selling the contract to another compliant company. However, the company cannot go ahead with the production as it does not meet the required discounted payback criterion. Currently the company is using its WACC to discount the project, however, if it uses the WACC of the new vehicles part industry, it will be more appropriate as it will encompass the entire risk associated with the project and then maybe the payback period can be increased as the risk related to the project will be taken care of by the new WACC. Therefore, it is advisable that the company reconsider its WACC for the project which would generally be high and if after that the project has a positive NPV, the company can go ahead with the project of manufacturing the vehicle parts instead of selling the contract to another company. Reference Fernandez, P., (2011), WACC: Definition, Misconceptions and Errors, IESE Business School, Working paper no. 914 Neufville, R., Clark, J., Field, F., (NA), Choice of Discount Rate, Dynamic Strategic Planning, Massachusetts Institute of Technology Drake, P., (NA), Capital Budgeting Techniques, accessed online on 25th April, 2017, available at, https://educ.jmu.edu/~drakepp/principles/module6/capbudtech.pdf Jacobs, M., Shivdasani, A., (2012), Do You Know Your Cost of Capital? Harvard Business Review