Capital budgeting tools

Capital budgeting tools

Introduction

The Drill Tech, Inc. is a mid-sized manufacturing firm whose location is in Minnesota. The finance manager was requested to evaluate three different potential projects to determine the one Project that will give the most investor value to the company.  Capital projects must be assessed to determine whether the cost of investment will provide enough benefit and outweigh any risks associated. While there are many various aspects in assessing the benefit or threat of a potential project, this evaluation is to determine the financial issues.  Each Project has its advantages and is very different from one another, but when taking the sales, cost of sales, tax, possible equipment depreciation and calculate the net cash flow and net present value, and informed financial decision can be made (Batra, & Verma, 2017). Therefore it’s important to note that the net current worth is one of the capital budgeting tools, which is strongly recommended to be used when analyzing the viability of the Project. Therefore in this paper, alongside other capital budgeting tools, the net present value will be given more priority in coming up with a project recommendation for Drill Tech, Inc.

As per the scenario, the three projects are a significant equipment purchase, expansion into Western Europe as well as marketing/advertising campaign. It’s out of these that one Project will be recommended for the company to undertake. The recommendation of the Project to be conducted can’t be a simple task without the use of capital budgeting tools. Through this, a more profitable project will be recommended for the company as it will be determined after conducting the necessary calculations using the capital budgeting tools using the excel spreadsheet.

Capital Projects Evaluation

Background

This company Drill Tech, Inc., as it has been mentioned from the introduction section, is a mid-sized manufacturing company based out of Minnesota.  The company’s finance manager has been tasked to conduct projects evaluation and come up with a worthy project to be undertaken. However, the main challenges associated with capital projects is that they increase with various markets. With some projects having inherent uncertainties since they encompass many moving parts, resources, and contractors that may keep changing over many years.

It must be appreciated that capital investment projects can impact a company’s value as well as increase its growth and returns on invested capital. According to (Yasotharalingam, 2016), a potential investment can either be qualitative or quantitative.  Qualitative projects are strategic, and hence they may address new mandates or regulatory requirements, on the other hand, quantitative investments have got clear financial goals.  For this portfolio, capital budgeting tools will be used to determine future project cash flows and determine which Project will bring the most value to shareholders.

The Capital Structure Theories

Various theories have been put forward to explain the nature of capital structures. Some of these theories include; the trade-off theory assumes that the optimum level of the obligation is where the marginal benefit of debt finance is equal to its minimal cost (Yasotharalingam, 2016). This theory explains that companies are financed with both debt and equity. Secondly is the Pecking order theory states that the cost of financing increases with asymmetrical information. Internal funding is easy to obtain and has the least amount of risk, so it is used first.  This theory posits that if domestic financing does not meet business requirements, they will borrow funds.  Equity is used as a last resort as it is least preferable and risky.

The Capital Budgeting Tools

These are the tools that are utilized in helping the company to determine whether a company should accept or reject a project.  The net present value investment rule, for instance, will tend to take a project if its net current value is greater than zero, that is NPV>0, and reject it if it is less than zero, that is NPV<0. It must be noted that a positive NPV will benefit the stockholders. The second tool is the Project’s internal rate of return, the internal rate of return (IRR) is based on the cash flows of the Project.  The cash flows calculate the actual performance—the higher the IRR, the better the investment.  The IRR is calculated by using expected cash flows, and the net present value is zero.  This calculation will give the anticipated rate of return earned on a projected investment.

The third capital tool is the payback period that tends to determines how long it takes to recover the initial investment.  An argument against this method is that capital budgeting relies on the time value of money, project profitability and additional cash flows after payback has been reached. Finally, the profitability index tends to measures the present value of future cash flows for every dollar of investment. The NPV and profitability index method can give contradicting results, but in general, the higher the PI, the better the Project is.

It must be noted that each of these tools should not be relied upon solely to determine whether a project should be accepted or rejected.  According to (Yasotharalingam, 2016). building on the internal rate of return can “lead to a poor decision about where to invest, especially when comparing projects that have different durations. “ Using the internal rate of return with net present value will provide a complete snapshot of a project’s cost and profitability.

Projects Analysis

The three projects will be analyzed about their net present value, the internal rate of return as well as the payback periods. From the provided information, all these project determinants can be calculated using an excel spreadsheet.

Project A: Major Equipment Purchase

Making use of the information provided from the scenario, the following is the calculations of the net present value of project A as they are computed in the excel spreadsheet.

Using the given information, the net present value, internal rate of return, payback period and profitability index are calculated as below, and the attached spreadsheet:

From the above attachment from excel, it’s clear that the net present value considering the second calculation option is $31.07 with an IRR of 70% and a payback period of 1.6 years. Therefore, in this case, the net present value of the Project is more than zero. But from the first option of calculation it was found to be less than zero, hence the reason as to why it’s not recommended to only rely on one tool of capital budgeting in deciding on project recommendation. It can also be witnessed that the profitability index of this Project is 4.107. Therefore in this Project, three parameters qualify it to be considered, that is the positive net present value, higher internal rate of return as well as the less payback period which renders the Project to be of low risk. However, this can’t be taken as a conclusive option for project A, the same will have to be carried out for projects B and C, and then a comparison is made (JUSTICE et al. 2020).

Project B: Expansion into Europe

For this Project, the calculations of the second option from excel displaying its net present value, the internal rate of return, as well as the payback period and the profitability index are as attached below.

From the above table, it’s clear that the net present value of the Project is more significant than zero. Also, from the Project’s internal rate of return, it indicates that the Project has got a higher magnitude as well as better timing of the incoming profits. It’s important to note that the higher the internal rate of return, the less risk is the Project. Also, it can be said that the payback period is less than one and a quarter year, which as well supports the less risk of the Project. This indicates the between project A and B; project B has to be undertaken since it is less risk. However project C must as well be considered (Chaudhary, 2016).

Project C: Marketing/Advertising Campaign

For this Project, the following was extracted from option two calculation in excel.

From the above table, it’s clear that the net present value of the Project is more significant than zero. Also, from the Project’s internal rate of return, it indicates that the Project has got a higher magnitude as well as better timing of the incoming profits. It’s important to note that the higher the internal rate of return, the less risk is the Project. Also, it can be said that the payback period is zero, which as well supports the less risky is the Project. This indicates the between project B and C; project C have to be undertaken since it is less risk (Kengatharan, 2016).

Recommendation

It’s important to note that from the above analysis, all the projects have got a payback period of fewer than two years. Both projects were observed not to be risky as noted from their IRR. However, in comparison, project C was found to be less risky as compared to the other two. This project C was also more profitable and with a net present value than the other projects. Therefore this indicates that the company will much benefit from project C than the other two.

Project C’s higher net present value, higher internal rate of return, lower payback period and higher profitability index shows that it creates more cash flow than the Project uses. This indicates that the company will tend to generate more cash flow as well as increasing the value of the investment via moving with moderate risk investment of the marketing as well as advertising campaigns (Batra, & Verma, 2017)

Reference:

Batra, R., & Verma, S. (2017). Capital budgeting practices in Indian companies. IIMB Management Review, 29(1), 29-44. Retrieved from https://www.sciencedirect.com/science/article/pii/S0970389617300587

Chaudhary, D. K. (2016). CAPITAL BUDGETING PRACTICES IN BEVERAGES INDUSTRIES IN NEPAL. International Educational Applied Scientific Research Journal, 1(1). Retrieved from http://ieasrj.com/journal/index.php/ieasrj/article/view/2

JUSTICE, A., YEBOAH, E. N., & PIOUS, O. (2020). Capital Budgeting as a Tool of Management Decision Making: A Case Study of National Investment Bank Limited. Retrieved from https://www.clutejournals.com/index.php/JBCS/article/view/9794

Kengatharan, L. (2016). Capital budgeting theory and practice: a review and agenda for future research. Applied Economics and Finance, 3(2), 15-38. Retrieved from http://redfame.com/journal/index.php/aef/article/view/1261

Yasotharalingam, L. (2016). Capital budgeting theory and practices (Doctoral dissertation, Kingston University). Retrieved from https://eprints.kingston.ac.uk/34118/