Introduction
Capital budget analysis refers to the process through which the way a firm invests capital in projects that result in cash flows over a period of more than one year. The analysis is built on the assumption that the firm depends on the specific project or projects under analysis in order to operate and consequently, it becomes important to test whether or not the projects being considered would be viable. Notably, capital budget analysis comes with several assumptions including the estimations of cash flows from the specific project as well as the assumption on the state of the economy as it relates to the capital project in question. Most importantly, it is important to note that while there are assumptions used in capital budgeting, proper care and research must be conducted to determine with certainty a range within which the economic parameters will fall. Based on this general description of what capital budgeting entails, this paper presents the capital budget analysis for Deluxe Corporation with regard to its consideration of a project investing a new cloth line targeting a different category of customers. The company has provided the basis of the consideration of the project and it is on this basis that the project is assumed to meet all other requirements other than the testing of the financial assumptions provided and in this light, the analysis will focus closely on the financial aspects of the proposed project (Kieso, Weygandt, & Warfield, 2010).
Deluxe Corporation targets the high-end clientele with its top of the range expensive clothes. In the recent past, a discounting strategy adapted by the company resulted rise sin the revenues of the company by opening the company to the middle class customers. However, the company is concerned that this strategy might erode its brand value and damage its image. The company is therefore considering investing in a new cloth line targeting the middle-income market and research has been completed on the same. Using the research findings, the paper presents the computed net present value and the internal rate of return supporting the decision of the company. The computations are as presented below.
The major entries to take note of in these computations include the research costs of $100,000. The costs will be paid with the first three months of 2016. The costs will be analyzed as part of the initial costs of the project at year 0. The second major entry is the computation of the depreciation amounts for the years 2016, 2017, and 2018. The depreciation was computed using straight-line method and 10% residual value on the $30 million value of the assets purchased at the beginning of the investment.
The analysis of cash flows indicates that initial cash outlay amounts to $46.1 million. The figure captures the amount invested in assets, the working capital, and the one-off research costs of $100,000. The net operating cash flows amount to $19.50 million in 2016, $21.75 million in 2017, and $25.50 million in 2018. The operating cash flows were computed by deducting the corporate taxes at 25% and adding back the annual depreciation of $9 million. The rationale of the computation is that depreciation is a non-cash expense. On the terminal cash flows, the analysis resulted in a value of $19 million, which captures a residual value of $3 million and the working capital of $16 million. The assumption is that the residual asset will be sold at the end of the investing period and that the working capital will be recovered in full.
Using the data as presented above, the project was analyzed using the net present value and the internal rate of return. The discounting factor used in the computation of the net present value was the risk-adjusted rate of 9%. The net present value of the project was found to be a positive value of $24.46 million. Under NPV as a method of project appraisal, the project should be accepted if the net present value is positive and rejected if the net present value is negative (Kieso, Weygandt, & Warfield, 2010). Consequently, value herein computed indicates that the project should be accepted. The application of the net present value model alone does not provide the analysis with an affirmative view on the decision that should be considered with regard to the project. This because the method of project appraisal does not provide the analyst with crucial information on where the return of the project stands in relation to the required rate of return in the organization. For instance, the method just helps in making the decision based on whether the NPV value is positive or negative and fails to consider other factors such as the required rate of return and this is the reason why the analysis herein provided also considers the internal rate of return on the project (Kieso, Weygandt, & Warfield, 2010).
The internal rate of return (IRR) was found to be at 33%. Ideally, a project should be accepted if the IRR is greater than the cost of capital, which is represented in this case by the risk-adjusted rate of 9% (Kieso, Weygandt, & Warfield, 2010). If the computed internal rate of return is lower than the discounting factor, the cost of capital, or the rate of return required by the investors, then the project ought not to be accepted. This distinction marks the importance of internal rate of return. Consequently, the recommended action is that the project should be accepted. In other words, the project to invest in a middle-income cloth line by Deluxe Corporation is considered to be a viable investment based on the findings that the net present value of the project is positive and having found that the expected return from the project exceeds the company’s required rate of return (Kieso, Weygandt, & Warfield, 2010).
Sensitivity risk analysis refers to the analysis of the project under varying risk conditions. The relevance of the analysis is to indicate whether the project would still be considered viable under the worst-case scenario, which is represented by the lower earnings before tax as shown in the table above (Kieso, Weygandt, & Warfield, 2010). Scenario A as indicated in the table has lower EBT, lower discounting factor, and lower tax rate. Considering the values above analysis resulted in a positive net present value of $26.80 and an IRR of 32%. Under Scenario B, which captures higher earnings before tax, higher rate of return, and higher taxes, the NPV was found to be $21.61 and the IRR was found to be 32%. The analysis therefore indicates that the project would still be considered as viable under both conditions.
The analysis can be extended to the worst case scenario and the best case scenario both of which are more important in sensitivity analysis than the analysis presented above. In the worst case scenario, the earnings before taxes are expected to be lower, the taxes are expected to be higher, and since the risk is higher, then the risk adjusted rate is also considerably higher. The taxes and discounting factor in this case are 32.5% and 10.8% respectively. In such conditions, the NPV was found to be $15.85 while the IRR was found to be 27%. The NPV is therefore still positive and the IRR is still above the cost of capital at 10.80%. Consequently, the project should be accepted.
Under the best-case scenario, the earnings before taxes are higher, the taxes are lower with the tax rate being at 17.5% and the required rate of return is lower at 7.2%. Under these conditions, the net present value computation returned $34.34 million in value while the IRR was found to be higher at 39%.
The final Output for the present values are as shown in the table and graph below
In conclusion, therefore, the analysis recommends that Deluxe Corporation consider investing in the project. This is because the NPV is positive under all the conditions herein presented and that the IRR is greater than the cost of capital under all the conditions presented herein. Assuming the company will finance the project through debt capital, it should be noted that the current capital structure of 68% equity and 32% debt may be affected to include 65.7% equity and 34.3% debt raising the weight of debt in the capital structure. In the new capital structure, the market capitalization or the value of equity is considered to be constant with debt increasing with the value of the initial outflow for the project. The company should therefore consider whether this is a desirable position for the company. Other non-financial factors may also require due consideration.
References
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2010). Intermediate accounting: IFRS edition (Vol. 2). New Jersey: John Wiley & Sons.
