Introduction
Many companies expand their operations through capital projects. Capital budgeting decisions are critical since capital projects involve a substantial outlay of financial resources. In addition, most of these projects are irreversible. It follows that a company must exercise due diligence in evaluating a proposed capital project before deciding to accept or refuse the proposal. Correct estimation of expected cash flows from the project is key to the sound evaluation of the viability of the project and hence an appropriate capital budgeting decision. This paper explores the costs and items included in the determination of cash flows expected from a project to manufacture golf clubs.
- Interest on debt
In the estimation of cash flows from the project, only incremental cash flows are considered. If the manufacturer uses debt to finance the project, the interest paid on the debt should be included in the costs of the project. The debt relates to the project since it is acquired for the sole purpose of financing the project. It is, therefore, an incremental cost of the project since the manufacturer will not borrow money if it chooses not to invest in the project (Bierman, 2010).
In addition, interest payments on the borrowed loan provide a tax shield against the income derived from the project. It will, therefore, have an effect on the cash flows hence it must be included in the estimation of cash flows. For instance, if the manufacturer issues 10% debentures worth $1,000,000 to finance the project, it will pay annual interest of $100,000. The interest will be included among the expenses of the project thereby reducing the project’s income before tax. However, since interest on debt is an allowable expense for purposes of taxation, it will reduce the income tax expense on the project’s income (Bierman, 2010). This will then increase the cash flows of the project with the amount of the tax shield.
Assuming the manufacturer’s tax rate is 35%, the annual tax shield will be $35,000. This implies that the manufacturer will pay $35,000 less than the amount of income tax it would pay if it did not finance the project through borrowing.
- Cost of studying golf
The cost incurred by the manufacturer last year to study golf clubs is classified as a research and development cost. Therefore, the $200,000 spent last year should not be included in the estimation of the golf club project’s cash flows. Since the cost has already been incurred, it is a sunk cost and irrelevant in the decision to accept or refuse the project (Booth & Cleary, 2010). This is because the decision to accept or reject the project will have no impact on the cost already incurred. Whether the project is implemented or not, the amount already incurred will not change.
Only costs that the manufacturer will incur if it accepts the project are included in the estimation of cash flows. The manufacturer should treat the cost of studying golf clubs as a research and development cost and then capitalize it (Booth & Cleary, 2010). The amount will be then be amortized every year for the appropriate number of years. In each year, the manufacturer should debit its overall income statement with the annual amortization expense. However, the manufacturer may capitalize the cost over the project’s useful life. Although the amount is irrelevant in the capital budgeting decision, it will increase the project’s annual expenses thereby reducing income tax expense. In this case, the manufacturer will enjoy a tax shield of $7,000 (20,000 × 35%) if it capitalizes the expenditure over a period of 10 years (golf club project’s useful life).
- Rent income
The $80,000 rent the manufacturer could get if it had rent out the factory that is storing the golf club machinery should be included in the determination of the project’s cash flows. The rent income is an opportunity cost of investing in the golf club project. If the manufacturer refuses the golf club project, it could gain $80,000 by renting out the factory. This indicates that the loss of rent directly occurs from the investment in the golf club. Opportunity costs are added to the total cost of the project (Baker & Powell, 2009).
- Effect on the profitability of the main business
The effect of the golf club project on the profitability of the manufacturer’s main business of manufacturing refrigerators should be taken into account in estimating the golf club’s cash flows. This is because it is an opportunity cost of the golf club project hence it must be included in the incremental costs and benefits analysis. Since the manufacturer’s main business will lose revenue if it invests in the project, the lost revenue is considered as part of the cost of the project.
The golf club project is expected to generate total revenue of $250,000 annually from the sale of golf clubs. The initial cost of the project amounts to $2,050,000. This amount includes the cost of machinery plus the cost of installing the machinery. In the determination of its cash flows, the cost of the increase in inventory is included since it is an incremental cost in respect of the project.
Estimates of cash flows indicate the project will generate negative cash flows for each of the ten years of its useful life. The NPV of the golf club project is -$2,261,883 indicating that the project is not viable. The negative sign of the NPV indicates that the present value of the project’s costs outweighs that of its benefits (Brigham & Ehrhardt, 2013). The manufacturer should, therefore, reject the project since it is not profitable. Unless the selling environment changes, the project will not generate adequate cash flows to recoup the initial investment of $2,050,000 in the project.
Conclusion
Cash flows of a project have a significant influence on the viability or otherwise of the project. In determining cash flows, all incremental costs and benefits of the project should be taken into account. Incremental costs include the interest paid on a debt security acquired to finance the project, as well as all opportunity cost. If the project causes a loss in profitability of the main business, the loss is an opportunity cost of the project. In addition, opportunity cost includes the rent the manufacturer will lose for not renting out the factory. Sunk costs such as costs incurred in studying golf clubs are irrelevant in determining the viability of the project. The assessment of the golf club project indicates that it has a negative NPV hence it is not viable. The project generates negative cash flows throughout its useful life hence the manufacturer would incur losses if it invests in the project. Therefore, the manufacturer should not invest in the golf club project.
References
Baker, H., & Powell, G. (2009). Understanding financial management: A practical guide. Malden, MA: John Wiley & Sons.
Bierman, H. (2010). An introduction to accounting and managerial finance: A merger of equals. Singapore: World Scientific.
Booth, L., & Cleary, W. (2010). Introduction to corporate finance (2nd ed.). Ontario: J. Wiley & Sons Canada.
Brigham, E., & Ehrhardt, M. (2013). Financial management: Theory and practice. (14th ed.). New York: Cengage Learning.
Appendices
Determination of cash flows
NPV
