Executive Summary
This paper deals with the analysis of various capital budgeting techniques for the replacement of the new equipment. The company has got the proposal for the replacement of the old equipment with the new equipment that will produce more and reduce the cost. Considering all the aspects necessary for capital budgeting like tax rate, initial outlay, annual cash flow and differential cash flow; the analysis is done. In simple words, it is like performing the feasibility analysis of the project in terms of finance. The techniques like IRR and NPV is used to make the decision. In addition to that, profitability index is also used to make the decision. Performing the sensitivity analysis of NPV at the various rate of return carries the analysis forward. Based on all these techniques, the replacement project is rejected.
Introduction
The Chief Finance Officer,
Dear Sir,
It is well known to you that capital budgeting comprises the determination of the worth of a potential investment. Our company has had several opportunities for investments and we have time and again confirmed the feasibility of that investment by measuring the potential of each of these investment opportunities. This time around, the question is whether we should install the new equipment that we expect will help in production capacity expansion of new products or the existing ones. This is the same situation like we faced earlier about whether we should invest in the new Research and Development of our new product.
For this new project too, like the previous projects three methods were considered: Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index.
The internal rate of a percentage value that is quite similar to what we would call an interest rate. It is a tool for comparison of capital investment when put together with other forms of investment. It is calculated by dividing the expected profit from the investment with the expected expenses throughout the project. There will be percentage that represents project returns. Then, the other projects of the Company are considered and minimum percentage of return that is acceptable is determined. This rate is also known as the hurdle rate. In case the value of IRR comes out to be higher than the value of hurdle rate, we could say that the project is worth investing. IRR is an easy concept to understand and that is why, it is used commonly in many Companies, with close competition from NPV results.
While using the net present value method for the calculation, there are two value concepts that are combined. The first is that it helps in the determination of the amount of cash that will be flown in given a certain amount of investment. It also determines the comparison of these results that will flow out of the project in comparison to the cash flows; given the investment to be made.
The generation of cash flows will take time, so the payoff of initial investment comes only much later. This means that the present values of future cash flows or the time value of money needs to be considered. This change in today and tomorrow’s values is because of the concept that money that has been earned today will not be the same worth in future, because of factors like inflation and others. The function of NPV is thus to calculate the outflows and inflows from the project over a period of time, taking into account the inflation factors and the rates of foreign exchange. The result is the expression of total benefit from the project over its life in terms of present money.
The final indicator known as the profitability index helps in the calculation and assessment of the association between the costs incurred and benefits earned for a proposed project by using ratio analysis. The formula for the calculation of PI follows that the present value of all the future cash flows is divided by the initial project outlay. When the profitability index is 1, it is possibly the least acceptable value of the index that can be taken. A value, which is less than 1, means that the initial investment is higher than the present value of all the accepted returns. A higher profitability index would mean that the attractiveness of the project at hand is also increased financially.
Out of the three methods taken, NPV is supposed to be the most reliable one. We could compare the different methods and then analyse what pros and cons they represent and why the other methods have not been used for the calculation and analysis part.
The major assumption that NPV has is that there is reinvestment of project cash flows at the level of hurdle rate, the basis being the comparable risk of the factors on which the project is typically based.
On the other hand, IRR has the assumption rule that IRR is the point at which the reinvestment of intermediate cash flows occurs. This assumption is implicit that there are many or in fact infinite projects lined up for the Company at a time and all of these projects yield the same IRRs. Thus, we could deduce that in cases where the value of IRR is high and the time periods of the return is also high, surplus value is created in the project and there is overstatement of the true returns that can be generated from the project.
If we compare the net present value method and profitability index method, there are similar rules for the acceptance and rejection of a certain project. This is because the value of Profitability index can only be high if there is positive net present value for a project. When the projects are marginal, the value of net present value will be zero and the value of profitability index will also be one. There may however be conflict among the two methods in case the choice is to made for mutually exclusive projects at a time.
In a similar manner, we can compare NPV with payback period and accounting rate of return so as to ensure its superiority. The calculation provided by payback period is that of the period at which the investment made in the project at the initial level will be recovered. The criteria for accepting or rejecting a project will be based on a benchmark point, against which the decision is made. If the payback period does not equal to the specified cut-off point, the project will be selected and in case it exceeds that period, there will be rejection of that project.
There are two primary cons associated with the calculation of payback period. The first is that there is ignorance of time value of money and the second is that there is no consideration for cash flows gained after the payback period has been reached. Discounted payback period is the extended version of payback period where time value of money is still considered to a certain level. It also does not however consider the cash flows after the payback period has been reached. Net present value of the other hand, considers time value of money and provides all the cash flows till the life of the project. NPV is thus the best option for making investment decisions. IRR and PI have been calculated just in case, to confirm the decision taken from NPV.
Here, the expected Cost of capital that the Company has is 10%. Let us now look at the calculations.
Calculations
Calculation of Initial Cash Outlay and Annual Cash Flow
Scrap value= Current market value- Current Book value
= 600,000- 400,000
= 200,000
Initial Outlay= Cost of New Machine- Scrap Value of old machine + increase in working capital
= 1,000,000-200,000+80000
= 800,000+80000
= 880000
Calculation of Annual Cash Flows on Year to Year Basis
The depreciation amount for the new machine calculation has been taken from the given information. It has to be noted that for the given scenario, the returns or benefits have been taken in the incremental form. This means that only the additional returns from the proposal have been taken. Thus, Rs. 60000 as the incremental depreciation has been considered. The same incremental depreciation has been added again to calculate the incremental values of annual cash flows.
The terminal cash flow is calculated by taking the total earnings given by the project at the end of its life. In this case, the new project will provide additional cash in the form of scrap value, which is given as
Thus, terminal cash flow: Annual cash flow at the end year+ Scrap value of the new machine
= 102000+200000
= 302000
Annual Cash flows from the Project in tabular form
Calculation of NPV, IRR, and Profitability Index for the replacement proposal.
Calculation of Net Present Value (NPV)
Since the net present value is negative, there should be no replacement of the new machine with the new one.
Calculation of Internal Rate of Return (IRR)
Theoretically, IRR is the point at which the value of NPV is equal to zero (0). In this case, the IRR has been calculated by using excel formula using the function IRR.
The IRR thus comes out to be -4%. This is much lower than the cost of capital. Thus, the replacement decision is not accepted.
Otherwise, IRR can also be calculated manually, by using the following formula
0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n, where P0, P1, . . . Pn represent the cash flows in the ten years of period respectively, 0 is the value of Net present value (NPV) and IRR gives the internal rate of return.
Profitability Index (PI)
Since the profitability index is less than 1, the project should not be replaced with the new one. There will be no enough return.
Final Decisions as per all three methods
In case there was a contrast between the decisions shown by the three methods, the result given by NPV would be considered.
Sensitivity Analysis
Next, we conduct a sensitivity analysis of NPV to the required rate of return falling between the ranges of 10% to 16% pa, with increments taken as 1%. This calculation has been done as per your expression of uncertainty at the top management level regarding the appropriate required rate of return to be used due to substantial decrease in risk-free rate over the years.
At 11%,
At 12%,
At 13%,
At 14%,
At 15%,
At 16%,
Thus, all the sensitivity analysis at different levels suggests that the project should not be accepted.
Conclusion and Recommendation
Based on all the methods of capital budgeting used, the project is rejected. The project has the negative NPV, which means that the firm will be losing money by investing in the new equipment. In addition to this, both IRR and profitability index rejects the project.
The crux from all this analysis is that though an investment may appear on the outside, there should be in-depth analysis so that the actual attractiveness of the project can be determined. In our case, the three methods of analysis, net present value, and internal rate of return and profitability index determine that the project need not be accepted. Thus, we should move on from the project and focus on two alternatives: optimizing the capacity of the current project or finding a new project. Whatever alternative is chosen, analysis will follow and the best solution will be taken. It is however important for the top management to understand basic capital budgeting terms and techniques so that the analysis can be minutely studied and approved at the larger level.
Thank you.
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