About the paper
The paper discussed the capital budgeting appraisal methodology employed for evaluating a capital project proposed to Deluxe Corporation. It is considerable that since such projects involves significant cash outflow and the decisions relating to these projects influence the entire organization, they must be taken with utmost care and on the basis of outcome of capital budget methods rather than own will. As part of evaluating the project we have employed three methods, i.e. NPV method, IRR Method, Profitability Index and Discounted Payback Period.
Cost to be included and excluded
Before we introduce the calculative part of this project, it is important that we discuss the relevant costs that should be included while evaluating the projects and the one that should be excluded:
i)Sunk Costs:
Sunk costs refer to cost that is generally paid to third-party professionals for pre-acceptance projections of the projects. Since these costs cannot be avoided and are not affected by accept or reject decisions, they should not be included in the project.
Here, the due amount of $100000 to the consultant for projections relating to the potential markets is an example of sunk costs and should be avoided
ii) Incremental after-tax Cash Flows
The relevant cash-flows to consider as part of capital budgeting process are the incremental cash flows, i.e. the changes in cash flows that will occur if the project is undertaken. In addition, all the cash flows should be accessed on after-tax basis as the project value is based on cash flows which they firm get to keep and not those they send to the government.
Evaluating the capital project
i) Net present value method
NPV is the sum of the present value of incremental cash flows less initial investment made. Important to note,the discount rate used while calculating NPV is the firm’s cost of capital,adjusted for the risk level of the project.
Therefore, while the average discount rate for the company’s project was 8%, the same was adjusted at 9% on account of higher risk involve in the project.
Decision point of NPV method:
If the NPV of the project is positive, accept the project
If the NPV of the project is negative, reject the project
It is considerable that NPV is considered to be the most sophisticated capital budgeting method and the outcome of the NPV method is directly related to shareholder wealth and stock price. In other words, if a company accepts project with a positive NPV multiple, it indicates that the project will enhance the shareholder wealth and will consequently result in higher stock price.
Referring to the table attached in the appendix section, we can see that the project yields positive NPV of $26,510,770. Henceforth, the project should be accepted.
ii) Internal Rate of Return
Internal rate of return is the discount rate that makes the present value of the expected incremental after-tax cash inflows equal to the initial investment of the project.
Decision Point for IRR:
If IRR is greater than the cost of capital, accept the project
If IRR is less than the cost of capital, reject the project
As we can see from the table included in the appendix section, IRR of the project is estimated at 35% that is significantly higher than the cost of capital of 9%. Henceforth, on the basis of IRR projection, the project should be accepted.
iii) Profitability Index
Profitablity Index is the present value of future cash flows divided by the initial cash outlay. This method is largely favored by small administration as it is closely related to NPV method on the basis of following expression:
PI=1 + (NPV/ Initial Investment)
Decision Point:
If profitability index is greater than 1, accept the project
If profitability index is less than 1, reject the project
Referring to the table attached in the appendix section, we can see that the project has profitability index of 1.58 and this confirms that the project should be accepted by the company.
iv) Discounted Payback Period
This method uses the present value of the incremental cash flows from the project in order to calculate the number of years it will take for the company to break-even their investment value. It is considerable that this method addresses the biggest drawback of the simple payback period, i.e. it ignores the concept of time value of money. However, still the method is least used by the companies as it ignores the cash flows after the payback period and is hence a poor measure to ascertain the project’s profitability.
Decision Point:
If the discounted payback period is equal or lower than the benchmark period set by the management, the project is accepted
If the discounted payback period is greater than the benchmark period set by the management, the project is rejected
Referring to the table attached in the appendix section, we can see that the discounted payback period is 2.06 years. Therefore, if this time period is acceptable to the management, they should accept the project.
Conclusion
On the basis of all of the capital budgeting methods employed to analyze the project, we can conclude that the addition of a clothing line to the company’s business will be a profitable affair for Deluxe Corporation and hence, the project should be accepted.
References
Capital Budgeting Techniques. (n.d.). Retrieved February 26, 2016, from http://shodhganga.inflibnet.ac.in/bitstream/10603/7277/9/08_chapter%202.pdf
Appendix
-Final Calculation
