Only for A-plus Writer
Anderson3426
capital_budgeting_powerpointm5a2.ppt.pptxGenesis Capital Budget
Capital Budgeting
Introduction
The decision on capital outlays is among the most significant a firm has to make. A decision to build a new plant or expand into a foreign market may influence the performance of the firm over the next decade.
The capital budgeting decision involves the planning of expenditures for a project with a life of at least one year and usually considerably longer. Capital budgeting helps in determining that how should a firm invest its capital.
Evaluation of the project
Different Capital budgeting options used are:
Payback period (which analysis the time or number of years which is required to cover the initial outlay or investment in the project),
Accounting Rate of return (this is also known as Return on investment, which measures the profitability of an investment considering its financial statements),
Discounted Payback period (which analysis the time or number of years which is required to cover the initial outlay or investment in the project considering the present value of all the cash inflows),
Net Present Value (it measures the present value of all the cash inflow from the project and compare the same with the initial investment, if the present value of cash inflows is positive then the project is accepted else it is not accepted NPV = Present value of cash inflows – Initial investment),
Profitability index (it measures the present value of cash inflows at the required rate of return to initial cash outflow of the investment.
Assumptions
These are the following assumptions which have been taken into account while evaluating the capital budgeting project:
Cost of Debt is assumed to be 8%
Cost of Equity is assumed to be 10%
Short term interest rate is 8%
Long term interest rate is 9%
Long term equity interest rate is 10%
Weighted Average cost of capital
Cost of capital helps us in determining the minimum rate of return a company is expected to earn from the proposed project. WACC is calculated on the basis of the market value of the capital structure of the company. The weighted average cost of capital or WACC is the weighted average of these three different components. We need to adjust the WACC depending on the riskiness of the project. If a project is riskier than normal projects, then we increase the WACC. If it is less risky, then we decrease the WACC. Thus, there is allowance for various risk factors in the WACC.
Weighted Average Cost of Capital
Cost of debt is the cost or return that the creditors of the firm demand on their borrowings. It is based on the interest rate and takes into consideration the tax factor. After tax cost of debt is taken for calculating WACC.
Cost of preferred stock is calculated on the dividend paid divided by the present value of the stock
Cost of equity can be calculated through dividend growth model as well as through CAPM, In this case we need to use the dividend growth model and cost of debt is based on the precost of debt after deducting the tax shield.
Weighted Average cost of capital
WACC = % of Debt x Cost of debt + % of equity x cost of equity + % of Preferred stock x cost of preferred stock.
WACC = 9.43%
Project A, B
Considering the three projects i.e project A, project B and Project C, we can state that project C has the highest NPV of 2083.18 with the IRR of 17% and payback period of 6.25 years, thus this project is considered to be the best option considering the perspective of all other projects.
Equipment 1
Equipment 1 which is fully automatic, semi automatic and manual. Considering the cash flows of these projects, it can be inferred that the manual equipment in equipment 1 has the highest NPV of $1665.69 with the IRR of 33% and payback period of 5 years. Thus the company should choose equipment 1.
Equipment 2
For equipment 2, the company has two options i.e. standard or top of line. Considering all the perspectives, we can say that the company should opt for equipment 2, where the NPV of the project will be $2998.42 and will give the IRR of 29%.
Equipment 3
For equipment 3, the company again has three options wherein the company should opt for 3 man machine. Though all the three equipment in this gives negative returns, the 3 man machine has the lowest negative return thus this machine should be chosen by the company.
Inspection vs Contract
The company should focus on in-house inspection as with that the company will be able to have the NPV of $1452.17 as compared to the NPV of $635.89 from contract inspection.
Metrics
| Metrics | Measurement |
| Financial perspective | |
| Increase in sales | More than 15% |
| Return on equity | 18% to 27% |
| Increase in net income | 15% |
| Increase in dividend payout | 15% |
| Customer perspective | |
| Increase in customer satisfaction level | 95% |
| Increase in customer base | 20% |
| Internal process perspective | |
| Improved quality | 85% |
| Decrease in operating cost | 12% |
| Increase in productivity and efficiency | 25% |
| Learning and growth perspective | |
| Decrease in employee turnover | 65% |
| Increase in employee morale | 75% |
Conclusion
From the above analysis and perspective we can say that the company should follow the strategic operating plan that has been developed after considering the cost that is associated with the project.
Thank You
