Introduction
Sports organizations can also use capital budgeting techniques to evaluate their capital projects. Sports firms must also invest in capital projects for expansion or to improve the efficiency of their operations. This paper explores two capital projects at motorsport firm using the various capital budgeting techniques.
Capital projects
The organization plans to purchase motorsport cars for hire. It has two alternatives X and Y. Car X will cost the organization $250,000 and is expected to have a useful life of 10 years. Its market value at the end of the tenth year is expected to be $25,000. It will also cost the firm $45,000 annually for repairs and maintenance of the car. On the other hand, Car Y will cost $200,000 and $30,000 in repairs and maintenance annually. It also has a useful life of 10 years with a salvage value of $20,000. The firm will incur fuel expenses since fuel expenses will be met by the customers who hire them. It is the policy of the organization to depreciate cars on a straight line basis. The firm will charge $1,500 for hiring Car X and $1,000 for hiring Car Y. The expected number of hires per annum is 150 for Car X and 200 for Car Y. The applicable tax rate for the organization is 30%.
Evaluation of the capital projects
The assessment of the two alternatives first involves the determination of cash flows.
Determination of cash flows
Workings for revenues:
Car X = $1500 × 150 hires = $225,000
Car Y = $1,000 × 200 hires = $200,000
As shown above the firm will earn an annual cash flow of $132,750 from Car X and $124,400 from car Y. In the tenth year, the net cash flow will include the market value/salvage value of each car.
Net Present value
This measure gives the difference between the present value of costs and that of benefits associated with each of the two cars (Parrino and Kidwell, 2009). It assumes that cash inflows generated from the cars are reinvested at the sports organization’s cost of capital. It is determined by discounting all the cash flows throughout the useful life of the car at the company’s cost of capital or an appropriate discount factor (Brown, 2010). A car whose NPV is positive is variable and should be considered for purchase (Wilson, 2011). In this case, the two cars are mutually exclusive hence the car with the higher NPV is selected. The NPV for each of the two cars is calculated as follows:
CAR X
Cost, C0 = $250,000
Annual cash flows, Ci = 132,750
Salvage value, SV = 25,000
n = 10 years
Discount rate = 10%
NPV = [(Ci × PVIFA10%, 10 years) + (SV × PVIF10%, 10 years)] – C0
= [(132,750 × 6.145) + (25,000 × 0.3855)] – 250,000
= 815,748.75 + 9,637.50 – 250,000
= 825,386.25 – 250,000
= $575,386.25
CAR Y
Cost, C0 = $200,000
Annual cash flows, Ci = 124,400
Salvage value, SV = 20,000
n = 10 years
Discount rate = 10%
NPV = [(Ci × PVIFA10%, 10 years) + (SV × PVIF10%, 10 years)] – C0
= [(124,400× 6.145) + (20,000 × 0.3855)] – 200,000
= 764,438 + 7,710 – 200,000
= 772,148 – 200,000
= $572,148
Internal Rate of Return
It refers to the discount rate at which the net present value of the car is zero. Unlike the net present value, the internal rate of return technique assumes that cash inflows from the cars will be reinvested at the internal rate of return (Kim, 2011). It is determined through estimation using methods such as interpolation, among others. The determined IRR is compared with the organization’s cost of capital to assess whether the car is a viable investment or not (Paramasivan and Subramanian, 2009). If the IRR of the car is more than the sports firm’s cost of capital, then the car is a viable investment. For two or more competing projects, the one with the highest IRR is selected.
Determination of IRR
CAR X
We try determining the NPV of the car at a discount rate of 55% (rate that gives a negative NPV):
NPV = [(Ci × PVIFA55%, 10 years) + (SV × PVIF55%, 10 years)] – C0
= [(132,750× 1.795) + (25,000 × 0.0125)] – 250,000
= 238,286 + 312.50 – 250,000
= 238,598.50 – 250,000
= -$11,401.5
IRR = A + P(P+N)(B – A) where A is the lower discount rate, B is the higher rate, P is the positive NPV and N is the negative NPV.
IRR = 10% + 575,386.25575,386.25+11,401.5 × (55 – 10)
= 10 + 44.13
= 54.13%
CAR Y
We try determining the NPV of the car at a discount rate of 65%
NPV = [(Ci × PVIFA65%, 10 years) + (SV × PVIF65%, 10 years)] – C0
= [(124,400 × 1.528) + (20,000 × 0.00669)] – 200,000
= 190,083 + 134 – 200,000
= 190,217 – 200,000
= -$9,783
IRR = 10% + 572,148572,148+9,783 × (65 – 10)
= 10 + 54.08
= 64.08%
As shown above, both cars have higher internal rates of return than the organization’s cost of capital. Therefore, they are bot viable for investment. Car Y has a higher IRR than that of Car X hence the organization should choose to invest in Car Y at the expense of Car X.
Profitability index
It is the sum of the present value of positive cash inflows per dollar of the initial cost of the car (Gitman and Hennessey, 2008). It is a relative measure hence is appropriate for comparing and ranking different investments (Helbæk, Lindest and McLellan, 2010). If a car has a profitability index of more than one, then it is profitable, and the firm should consider it for investment. In this case, there are two competing cars hence the better choice should be the car with a higher profitability index (Wilson and Joyce, 2008).
Determination of Profitability Index
CAR X
Present value of positive cash flows = [(Ci × PVIFA10%, 10 years) + (SV × PVIF10%, 10 years)] – C0
= [(132,750 × 6.145) + (25,000 × 0.3855)]
= 815,748.75 + 9,637.50
= $825,386.25
Profitability index = 825,386.25250,000
= 3.302
CAR Y
Present value of positive cash flows = [(Ci × PVIFA10%, 10 years) + (SV × PVIF10%, 10 years)]
= [(124,400× 6.145) + (20,000 × 0.3855
= 764,438 + 7,710
= $772,148
Profitability index = 772,148200,000
= 3.861
Both cars have profitability index of more one hence they are profitable. Car Y has a higher profitability index hence the firm should purchase Car Y.
How the discount rate was determined
The discount rate used is the weighted average cost of capital of the organization which comprises both the cost of equity as well as the cost of debt in the capital structure (Moles, 2011). The two capital projects do not have higher than normal risks hence there is no need to adjust the discount rate.
Sensitivity analysis
Changes in cost
The above analysis indicates that the NPV of both cars has the same sensitivity to changes in the initial cost. NPV for both cars increases by 9% if the initial cost is increased by $50,000. A reduction in the cost by $50,000 increases the NPV of each of the cars by 9%.
Sensitivity analysis of the discount rate shows that the NPV of X is more sensitive to changes in the discount rate than that of Car Y. A reduction in the discount rate from 10% to 6% causes an increase of 28.78% in the NPV of Car X. The same change only leads to a 27.78% increase in the NPV of Car Y. This suggests that Car X is slightly riskier than Y since the NPV is more sensitive to these changes.
Justification for the use of NPV
As shown in the analysis above, NPV gives a different decision from the decision under IRR and profitability index. In this case, NPV should be used to select one of the cars and not basing the decision on IRR or profitability index. NPV is the most suitable since it gives an absolute value of the net benefits. For instance, the net benefits of buying car X is $575,386. The other methods are relative measures and do not show the absolute value of the expected benefits.
Being relative measures, IRR and profitability index are not suitable for comparing projects with unequal initial costs. IRR may choose a project with a lower absolute net benefit at the expense of the one with higher benefits. In the above analysis, Car Y has a higher IRR than Car X. IRR technique chooses Car Y over X while it is clear that Car X will give the organization more net benefits than Car Y.
The assumption of IRR that the cash flows are reinvested at the IRR is unreasonable. The IRR is usually high and rarely do projects generate such returns (Berk, 2010). In this scenario, the IRR for the two cars is 54% and 64% respectively. These rates are unrealistic. Besides, the determination of IRR is purely trial and error hence determining the exact IRR may not be possible. IRR also has the problem of giving multiple rates for the same project especially if there are unconventional cash flows.
Conclusion
Both cars are viable when evaluated under NPV, IRR and profitability index techniques. NPV selects Car X while IRR and profitability index selects Car Y. NPV is more reliable and most reasonable hence this decision should be based on the NPV criterion. Therefore, the firm should buy Car X.
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