Finance department plays a dominant role in the long run productivity of an organization. There is a marginal different lies between accounts and finance. Accounting refers to the recording and articulating the data while finance deals with the utilization of funds at a place from where the likelihood becomes easy.
Capital Budgeting is one of the most important branches of Finance, which deals with the analysis of the future of a project which an organization is wishing to undertake. Organizations have to consider the working of capital budgeting in order to take only those projects which actually increases the worth of the company.
There are certain tools used specifically for capital budgeting and project evaluation purpose. The main perspective of this assignment deals with a case study of capital budgeting and project evaluation. There are different characters present in the case study which are the upper management personnel of a company. We are supposing as the financial consultant who later on start his work to analyze the proposals. There are two proposals which are in consideration of this assignment which predominantly are Project X and Project Y. Some of the specification given in the case study is mentioned below,
There are basically two steps involved in this computation. First of all, we have given the actual quantity which will produce by the company which will be 150,000 units which increases by 8% for the next 4 years. Each unit will be sold at a price of 40. Each year, the sale revenue also increased by 8% while the operating cost covering an initial cost of 16 a unit also increased with the same proportion.
The next table includes the initial outlay of 2.2 million pounds and then the depreciation computed with the help of Straight Line Method (SLM). A value of 4, 40,000 pounds has been depreciated each year for the next 5 years of the machine of project Y. Working capital which has been computed as 12% of the total revenue excluded from the initial outlay.
We have arrived on the net income figure after deducting depreciation, tax and operating cost from the sales revenue. Please note that we have still not reached on the cash flow from operation and from investment which will be used later on in project evaluation. There is another table which computed the same,
Net Present Value (NPV)Finally, we have reached on the cash flow which will be used in further analysis. The final cash flows are 3048,000, 3192000, 3405120, 3635290 and 3883873. Now we have 3 different tools which will be used here project evaluation. The three tools which will be used here are Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI). After computing these things, analysis will be done to analyze will the company has to accept the project or should not.
Net Present Value (hereafter NPV) is the most widely used tool to assess the economic compatibility of a particular project. Basically the NPV which is also called Net Present worth (NPW) is a time series of cash flows which are both ingoing and outgoing is called NPV. Basically it is the sum of all the present values of the individual cash flows (Edwin & Ruud, 2000). NPV is very useful in the world of finance and has been counted as the central tool to appraise the long term projects with the help of discounted cash flow techniques and time value of money factor.
NPV is the most powerful tool to analyze a project. Project managers and financial analysts use this particular tool to analyze the actual worth of a project. With the help of this tool a manager becomes able to analyze that whether or not the project will actually increase or decrease the worth of the company. The hurdle rate or Weighted Average Cost of Capital of Project Y is 16%. Mentioned below table analyzes the NPV of project Y.
We analyze that, project Y can be accepted easily because of its positive NPV. The main issue here is that there is another project which is Project X and the company has to make a mutually exclusive choice, like they have to select only a single project instead of one. Project X NPV analysis is mentioned below,From this analysis, it can be clearly seen that Project Y will actually increase the worth of the company as the NPV of the company lies in positive term. From the analysis, it is found that the NPV of the company is more than 8.8 million GBP which is very handy from the viewpoint of a company. The cash flow which we have computed through capital budgeting is increasing year on year (YOY) by a reasonable percentage of 8% which then be discounted at a rate of 16% of WACC.
Internal Rate of ReturnNow, the comparison is extremely easy. Project Y can increase the worth of the company more than by 8 million GBP, while Project X can only increase the worth by 2.1 million GBP. Hence, the company has to look forward to invest in Project Y rather than in project X.
Internal Rate of Return (IRR) is another widely used tool to analyze a company or project before taking it. IRR is the rate on which the NPV of the project becomes zero. If the computed IRR comes out greater than the discount or hurdle rate then the project should be taken.
Apart from IRR, Modified Internal Rate of Return (MIRR) is another tool to analyze the company. MIRR is a rate which initially computes through IRR and then reinvests the same on some rate (Edwin & Ruud, 2000). This particular tool is not widely used by the companies to analyze the projects and companies. This is another important tool which has been used by the companies to evaluate the effectiveness of a project.
The actual hurdle rate or WACC of the project is 16% and the computed discounted IRR is 108% which is way higher than the actual WACC of the company, hence according to the law, the project must be selected; let’s now compute the IRR of project X for the comparison.
IRR which is again an important tool is manifesting that project Y is superior to project X because of high amount of NPV and IRR. The discounted IRR of the projects are 108% and 32% of project Y and Project X respectively and the company should go for the larger one.
Profitability Index (PI)
Profitability index (PI) which is also called the Profit Investment Ratio (PIR) is another widely used ratio in the world of finance. This particular tool is used to rank the projects and it is used with the NPV of the project. If the PI of the project comes more than 1, then one have to invest in this project otherwise one must abrogate the idea of investing in the project (Edwin & Ruud, 2000).
ConclusionAccording to the rule, will be more than 1 to select. Here the PI is 4 and it should be select accordingly.
The entire world is moving with a lightning speed and continuously apprising that the current era is the era of globalization and technology (Edwin & Ruud, 2000). Globalization is a situation in which a single effect leaves an ultimate effect over the other thing as well. Due to the globalization, the insurgence of new companies has increased tremendously which is inevitably contributing in the long run economic growth of the companies (Edwin & Ruud, 2000).
Business decisions are always difficult to take because of it sophisticated nature. There are numerous methods come under the ambit of taking business decisions for an organization.
From the entire analysis, it can be said that the company should go with the investment in Project Y rather than Project X.