Introduction
Capital budgeting assists sports organisation in assessing the viability of their proposed long-term investments (Chandra, 2014). Sports organisations also need to invest in capital projects for expansion as well as to improve the efficiency of their operations. Extreme Sports Company operates a sports training complex with a fitness centre, motorsport cars for hire, among other services. The company has some money to invest in the expansion of either the fitness centre or the motorsport unit. This paper highlights how the company can use capital budgeting techniques to evaluate the two investment options.
Details of the two projects
The motorsport car will cost $200,000 and will operate for five years after which it will be sold at a price of $20,000. The firm does not incur any fuel expenses since the clients cater for the fuel. It is estimated that the firm will incur an annual cost of $25,000 in repairing and maintaining the car. The company will also incur an insurance cost of $5,000 per annum. The firm charges a price of $1,000 for hiring the car and estimates that it will get about 100 hires per year.
The company can use expand its gym facility by purchasing gym equipment including gold dumbbells, a vibrator for quads and wind tunnel. The equipment will cost $210,000 and will have an economic life of 5 years with a salvage value of $40,000. The equipment will cost about $1,000 annually in repairs and maintenance. The firm will hire two operators who will earn $200 each per month. Clients of the fitness are annual subscribers, and the company charges $200 per annum. It expected the fitness centre would have an additional 300 subscribers if it buys the equipment.
Determination of cash flows
Motorsport Car
Car hire revenue ($1,000 × 100 hires) 100,000
Less Cash expenses
Repair and maintenance cost 25,000
Insurance expense 5,000 (30,000)
Net annual cash flows 70,000
Gym equipment
Subscription revenue ($200 × 300) 60,000
Less expenses
Repairs and maintenance 1,000
Operator salaries ($200 × 2 × 12) 4,800 5,800
Net annual cash flows 54,200
Discount rate
This is the rate at which the cash flows will be discounted to determine their present worth. It is the cost of capital of the organization (Guerard and Schwartz, 2007). Since the organization financed the investment using both equity and debt, the discount factor is the average cost of capital which includes both the cost of equity and the cost of debt. When the investment projects carry a higher risk, the discount rate may be adjusted to reflect this (Hillier, 2010). In this case, such adjustment is not necessary. The average cost of capital for the organization is 10%.
Determination of NPV
NPV is determined by finding the difference between the present values of cash flows and the cost of the project (Hillier, 2010). The cash flows of the two investment alternatives are discounted at a discount rate of 10%. NPV assumes that the cash flows generated by the two investments will be reinvested in the firm at the firm’s cost of capital. The sum of the present values of annual cash flows is determined and the initial cost subtracted from this sum to determine the NPV.
The essential condition for NPV is that a project must have a positive value for the project to be considered viable. Where there are two or more alternatives, the NPV technique selects the alternative that has the highest net present value.
NPV = Sum of present values of annual cash flows + Present value of salvage value – Cost
Discount rate = 10%
Period = 5 years
PVIFA10%, 5 years = 3.7908
PVIFA10%, 5 years = 0.6209
Motorsport car
NPV = (70,000 × 3.7908) + (20,000 × 0.6209) – 200,000
= 265,356 + 12,418 – 200,000
= $77,774
Gym equipment
NPV = (54,200 × 3.7908) + (40,000 × 0.6209) – 210,000
= 205,461 + 24,836 – 210,000
= $20,297
The above results indicate that both projects are viable since they have positive net present values. Motorsport Car has a higher NPV than the gym equipment. Therefore, Extreme Sports Company should invest in the motorsport car.
Comparison of NPV to other techniques
Payback period
Motorsport car = 200,000/70,000 = 2.857 years
Gym equipment = 210,000/54,200 = 3.8745 years
The above results show that it will take the company 2.857 years and 3.8745 years to recover the initial cost of the racing car and gym equipment respectively. The racing car has a shorter payback period than the gym equipment hence the management should invest the money in purchasing the racing car (Keown, Martin and Petty, 2008).
Profitability index
Profitability index = Sum of positive PVs/initial cost
Motorsport car = 277,774/200,000 = 1.3889
Gym equipment = 230,297/210,000 = 1.0967
Both projects have a profitability index of more than one hence they are both viable. However, the racing car is more viable since it has a higher profitability index (Megginson and Smart, 2008).
Why NPV is the most suitable technique
NPV, unlike the payback period, considers the effect of the time value of money hence it incorporates the risk involved in future cash flows (Needles, Powers and Crosson, 2010). Besides, it applies all the cash flows generated by the project in the assessment of the viability of the project. The payback period ignores the cash flows generated after the payback period hence may give a misleading result (Röhrich, 2014). The advantage of NPV over profitability index is that it is an absolute measure and gives the actual net benefit while profitability index is a relative measure. While comparing unequal projects, profitability index may be misleading since a project with less net benefit can have a higher profitability index than one with more net benefit (Weygandt, Kieso and Kimmel, 2010). Besides, the premise of the NPV criterion that cash flows generated are ploughed back to the firm at the discount rate is reasonable.
Sensitivity analysis
Sensitivity analysis measures the risk involved in each of the projects by determining the impact of changes in variables on the NPV of the project (Berk and DeMarzo, 2011). A project that is highly sensitive to changes in variables is considered to be carrying a higher risk than one that is less sensitive.
Change in the cost of capital is one of the factors that can affect the profitability of a project. As shown in the above graph, the curve for Gym equipment is steeper implying that it is more sensitive to changes in the discount rate than the racing car (Ryan, 2007). For instance, if the cost of capital increases from 10% to 12%, the NPV of gym equipment declines by 60.21% while that of the racing car only declined by 18.21%. This shows the investment in gym equipment is riskier than the investment in racing cars.
Conclusion
The NPV of the car is higher than that of gym equipment hence the company should invest in the racing car. Besides, the NPV of the gym equipment is more sensitive to changes in the discount rate than that of the racing car. Investment in the gym equipment carries a higher risk than the investment in the racing car. The NPV criterion is the most appropriate of all the capital budgeting techniques.
Bibliography
Berk, J. and DeMarzo, P. (2011). Corporate finance. Boston, MA: Prentice Hall.
Chandra, P. (2014). Fundamentals of financial management. New Delhi: Tata McGraw-Hill
Education.
Guerard, J. and Schwartz, E. (2007). Quantitative corporate finance. New York, N.Y.:
Springer.
Hillier, D. (2010). Corporate finance. London: McGraw-Hill Higher Education.
Keown, A., Martin, J. and Petty, J. (2008). Foundations of finance. Upper Saddle River, N.J.:
Pearson Prentice Hall.
Megginson, W. and Smart, S. (2008). Introduction to corporate finance. Southbank, Vic.:
Thomson/South-Western.
Needles, B., Powers, M. and Crosson, S. (2010). Principles of accounting. Boston, MA:
Houghton Mifflin Co.
Röhrich, M. (2014). Fundamentals of Investment Appraisal. Berlin: De Gruyter.
Ryan, B. (2007). Corporate finance and valuation. London: Thomson Learning.
Weygandt, J., Kieso, D. and Kimmel, P. (2010). Managerial accounting. Hoboken, NJ:
Wiley.
