Capital-Budgeting Analysis Essay Sample
Determining the net investment
The first step in the investment appraisal is to determine the net investment. Based on the data from the case it is a very straightforward calculation, as there is no sale of any existing equipment or any other adjustments involved.
The business should decide whether to invest $ 7 million for 5 years. Once the investment will have undertaken, the recovery (terminal) value of the expenditure at the end of 5 years are considerably lower than initial investment.
Estimation of cash flows
Real estimates of the cash flows related to an investment project are key to the correct appraisal. It appears that the case at hand has considerable uncertainty both in revenues as well as in contribution margin. Therefore different scenarios have been considered in the course of appraisal as follows:
The following table depicts projected cash flows under the base scenario- the most likely one according to Mr. LaGrande.
All calculations for this as well as the remaining 5 scenarios are shown in the Excel spreadsheets accompanying this paper.
Calculation of ROI and ranking
Among the different investment appraisal methods NPV and IRR are considered to be most appropriate because they take into account all costs and benefits as well as timing of those costs and benefits. As can be seen from the table above, this is done by the deployment of a discount rate, which is 16% in this case. This application of the discount factor allows to bring all cash flows to one point in time, as if they have taken place now (Atrill and McLaney, 2009). The main rule under NPV is to accept investment proposals with positive NPV as they increase shareholders wealth and to reject investment proposals with negative NPV as they reduce shareholder value, though in accounting terms there may be a profit. IRR is closely related to NPV method by providing yield of the investment proposal. If IRR is in excess of the required rate, then the project could be accepted, and if it is less, then the project should be rejected. The following table depicts possible range of NPV and IRR of the project depending on the scenario.
It should be mentioned that the case at hand provides information only about one project. If there are competing projects and the amount of capital is limited, different projects should be prioritized in the manner described above. The table clearly indicates that the scenarios 2, 3, 4 pass the threshold of 16% and positive NPV, while the remaining scenarios fail to increase shareholders value.
Regarding this particular project, it is recommended not to approve it at this stage due to the negative NPV of the base (most likely) scenario. If management can assure that gross margin of 58% is likely to be achieved then this decision could be revisited. Westerfield et al (2009) point out, in real life business people often have uncertainty over the future cash flows and the decisions regarding projects are quite complex.
Atrill, P., & McLaney, E. (2009). Management accounting for decision makers. Pearson
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J.
(2002). Introduction to Management Accounting: Chapters 1-17. Prentice Hall.
Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. (2009). Corporate finance: Core principles &
applications. McGraw-Hill Irwin.
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