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Introduction

Capital budgeting is replicated as process in which business evaluates and identifies potential huge expenses along with investment. Generally, expenditures and investments comprises projects like building a new plant or to invest in tenure for long term perspective. This report will explain the fundamentals of corporate finance stemming through different underlying theoretical and principles along with use of principles. Simultaneously, it will communicate range of different arguments in discipline of corporate finance which is proper to audience, via varietal communication media (Ermasova  and Ebdon, 2019). However, this report is an problem solving exercise with use of Excel spreadsheet and leads to high accuracy.

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Scenario

Given that:

  • WACC or cost of capital: 20%
  • Tax rate: 30%
  • 10% debenture of $10000000

Extraction of cash flow

Q Powerboat

Table 1

Year

 Quantity

 Per boat price

Sales revenue

Less: Variable cost @ 40%

Less: Fixed factory overhead

Less: depreciation

EBIT

 

 

 

 

 

 

 

 

1

650

30000

19500000

7800000

200000

2496000

9004000

2

600

30000

18000000

7200000

200000

2496000

8104000

3

550

30000

16500000

6600000

200000

2496000

7204000

4

500

30000

15000000

6000000

200000

2496000

6304000

5

450

30000

13500000

5400000

200000

2496000

5404000

6

400

30000

12000000

4800000

200000

2496000

4504000

The above scenario is depicting extraction of Earnings before interest and tax over 6 years with use of sales revenue. The per boat price has been specified which is multiplied with quantity of total sale revenue. Further, variable cost has been excluded which is 40% of sales and factory overhead is fixed 200000 over 6 years. Moreover, depreciation is extracted as 2496000 which is also excluded and it originated EBIT of Q Powerboat.

Table 2

Year

EBIT

Less: Interest

EBT

 tax @ 30%

EAT

Add: Depreciation

Cash inflow

 

 

 

 

 

 

 

 

1

9004000

1000000

8004000

2401200

5602800

2496000

8098800

2

8104000

1000000

7104000

2131200

4972800

2496000

7468800

3

7204000

1000000

6204000

1861200

4342800

2496000

6838800

4

6304000

1000000

5304000

1591200

3712800

2496000

6208800

5

5404000

1000000

4404000

1321200

3082800

2496000

5578800

6

4504000

1000000

3504000

1051200

2452800

2496000

4948800

The table 2 is giving calculation of cash inflow which is extracted with EBIT calculated in above scenario. At the first step, to reach EBT interest is excluded  and to attain EAT 30% tax was deducted as well (Mubashar and Tariq, 2019). Depreciation is considered as accounting method to allocate cost of tangible asset over its useful  life and is implicated for accounting for declining value. It is a non cash accounting charge which does not affect amount of generated cash flow by company. The final cash flow is calculated by adding depreciation in earnings after tax.

Table 3: Assessment of inflows from powerboat parts:

Year

Powerboat cost

Variable cost @ 40%

Less: loss of income

Cash inflow

 

 

 

 

 

1

500000

200000

120000

180000

2

1000000

400000

120000

480000

3

1500000

600000

120000

780000

4

2000000

800000

120000

1080000

5

2500000

1000000

120000

1380000

6

3000000

1200000

120000

1680000

The table 3 is reflecting assessment of inflows through parts of powerboat, as here cost of powerboat is specified in 1st column and variable cost is at rate of 40% which is deducted and even loss of income as well. Its outcome of cash inflow is extracted over 6 years for assessing inflows through powerboat reports.

Table 4: Computation of net cash inflow

Year

Cash inflows from Powerboat

Cash inflow from Powerboat parts

Net cash inflows

 

 

 

 

1

8098800

180000

8278800

2

7468800

480000

7948800

3

6838800

780000

7618800

4

6208800

1080000

7288800

5

5578800

1380000

6958800

6

4948800

1680000

6628800

The table 4 would help in computing net cash inflow which is difference among cash inflow of company and outflow of specified duration. However, in this aspect cash inflow from powerboat and power boat parts is aggregated in this table of past 6 years.

Table 5: Computation of Net present Value

Year

Cash inflow

PV factor @ 20%

Net present Value

 

 

 

 

1

8278800

0.833

6896240.4

2

7948800

0.694

5516467.2

3

7618800

0.579

4411285.2

4

7288800

0.48

3513201.6

5

6958800

0.402

2797437.6

6

6628800

0.335

2220648

 

 

 

 

  Total discounted cash inflow

 

 

25355280

  Less: Initial investment

 

 

21300000

  NPV

 

 

4055280

Net Present value is known as difference among present value of cash inflows and present value of cash outflows over particular duration. It helps in analysing profitability of forecasted investment or project. The Table 5 gives brief details related to net present value over 6 years (Maáji and Barnett, 2019). Its PV factor and discounted at 20% and it leads to aggregate of discounted cash flow of 25355280. In this project, its initial investment was extracted as 21300000. However, step for calculating Net present value, initial investment is excluded from total discounted cash flow ao with this context its net present value is 4055280 (25355280 – 21300000).

Working note:

Assessment of initial investment

Particulars

Figures

Cost of plant

$20,000,000

Installation cost

$800,000

Initial investment in stock

$500,000

 

 

Total initial investment

$21300000

Computation of depreciation

Particulars

Figures

Cost of plant

$20,000,000

Installation cost

$800,000

Sum of initial investment

$20,800,000

 Estimated selling prices

$3,000,000

Period

6 years

Straight line rate

12%

Depreciation

$20,800,000 * 12%

= 2496000

On basis of assessing initial investment extracted with help of cost of plant, installation cost and initial investment in stock. The extraction of initial investment is very important for every method of capital budgeting and helps for taking appropriate business decisions. In the same series, calculation of depreciation is also replicated at straight line method with 12% rate and applicable for 6 years and its final depreciation amount is 2496000.

Table 6

Computation of Payback period

 

 

 

Year

Cash inflows

Cumulative cash inflows

1

8278800

8278800

2

7948800

16227600

3

7618800

23846400

4

7288800

31135200

5

6958800

38094000

6

6628800

44722800

Initial investment

 

21300000

Payback period

 

3

 

 

0.7

Payback period

 

2 year and 4 months

The above table is analysing payback period of Q powerboat which helps in reaching break even point or it could be elaborated that where initial investment cost is covered. Its initial investment is 21300000 which is covered in 2 years and 4 months (Srithongrung and et.al., 2019).

S Powerboat

In this aspect, cash inflows of S powerboat is analysed with use of two capital budgeting method as payback period and other is Net present value.

Table 7: Computation of payback period

Year

Cash inflows

Cumulative cash inflows

1

6400000

6400000

2

7400000

13800000

3

7900000

21700000

4

8600000

30300000

5

9300000

39600000

6

14100000

53700000

Initial investment

 

21300000

Payback period

 

2

 

 

0.9

Payback period

 

2 year and 9 months

The above table is giving extraction of payback period of 6 years of S powerboat as its initial investment is similar to Q power boat as 21300000. It is clearly viewed that in total 2 years and 9 months it's initial investment was covered.

Table 8 Calculation of NPV

Year

Cash flows

PV factors @ 20%

Discounted cash inflow

 

 

 

 

1

6400000

0.833

5333333.333

2

7400000

0.694

5138888.889

3

7900000

0.579

4571759.259

4

8600000

0.482

4147376.543

5

9300000

0.402

3737461.42

6

14100000

0.335

4722061.471

Total discounted cash inflows

 

 

27650880.92

Less: Initial investment

 

 

21300000

Net present value (NPV)

 

 

6850880.92

Net present value is extracted by difference from total discounted cash inflows and initial investment of over 6 years. There is consideration of time value factor and its discounted factor is at rate of 20% of specified duration. However, its initial investment was 21300000 and aggregate of discounted cash inflow is about 27650880.92 of this duration. Henceforth, its net present value is 6850880.92 which is acceptable as well.

Comparison of Q boat and S boat

Particulars

Q boat

S boat

Payback period

2 years and 4 months

2 years and 9 months

Net Present Value

4055280

6850880.92

The above table is stating difference in Q powerboat and S powerboat, or in simple words, which project is favourable to organization and gives high benefit with similar initial investment of 21300000. On basis of pay back period, Q power boat is highly advantageous because of fast recovery of initial investment cost as it has variation of 5 months. On the contrary, with consideration of net present value S powerboat is acceptable because of high positive value as compared to Q power boat (Srithongrung, Yusuf and Kriz,  2019). Henceforth, it has been recommended to select S powerboat for investment because it has high net present value and it considers time value of money as well. The payback period does not involve time factor which is great limitation because in the present scenario, it is most important factor for attaining success and make business decisions.

Conclusion

On basis of above report, it could be concluded that capital budgeting helps in undertaking various business decision and for making strategic plans. It has shown stepwise calculation for extracting cash flow and it has also shown importance of depreciation for analysing business strategic decisions. Thus, it has articulated importance of time value of money concept and here S powerboat is suggested to investment and for benefit.

References

  • Ermasova, N. B. and Ebdon, C., 2019. The Case of Public Capital Budgeting and Management Processes in the United States. In Capital Management and Budgeting in the Public Sector (pp. 23-48). IGI Global.
  • Maáji, M. M. and Barnett, C., 2019. Determinants of Capital Budgeting Practices and Risks Adjustment among Cambodian Companies. Archives of Business Research. 7(3).
  • Mubashar, A. and Tariq, Y.B., 2019. Capital budgeting decision-making practices: evidence from Pakistan. Journal of Advances in Management Research. 16(2). pp.142-167.
  • Srithongrung, A., Yusuf, J. E. W. and Kriz, K. A., 2019. A systematic public capital management and budgeting process. In Capital management and budgeting in the public sector (pp. 1-22). IGI Global.
  • Srithongrung, A.and et.al., 2019. Capital management and budgeting in the public sector. IGI Global.

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