Project Analysis Through Capital Budgeting

Question: Discuss about the Report for Project Analysis Through Capital Budgeting. Answer: Introduction The given company Alata Plc wishes to introduce a new product in the market and wants to ascertain the financial feasibility of the project by taking into consideration the underlying implementation and feasibility issues. On the basis of the given information, the given report aims to carry out the analysis of the given project and whether the same should be implemented or not. In this regard, the capital budgeting techniques have been used to ascertain financial viability. Determination of relevant cash flows The cost for the research before the introduction of the product to the tune of 270,000 would be a sunk cost as it has already been incurred and could not be prevented irrespective of the final decision with regards to the project. Hence, this would be an irrelevant cost for the given project analysis (Damodaran, 2008). The incremental cash inflows would arise on the account of incremental revenues realised through the product sales based on the estimate provided for each year for the entire useful life of four years. Initial cost of machinery (at t=0) = 1.5 million Annual depreciation cost = 1.5/4 = 0.375 million Salvage value of machinery (at t=5) = 0.3 million The rent cost would be considered a sunk cost as the premises is expected to stay empty only in the foreseeable future and also due to the presence of contract the company is obliged to pay the rent on the premises (Petty et. al., 2015). Unit raw material cost = 10*0.5 = 5. However, from year 2 onwards this cost is expected to increase at the rate of 10% pa. Unit direct labour cost = 8 *0.25 = 2. No increases are scheduled in this regard. The interest cost would not be considered in the project evaluation as the same would be reflected in the cost of capital and thus would not be included in the evaluation process. Further, for the given project evaluation, it would be assumed that there are no taxes. As a result, there would not be any tax savings due to depreciation and thus depreciation being a non-cash charge would be ignored (Parrino Kidwell, 2011). The incremental cash flows arising from the project are summarised in the table below (Graham Smart, 2012). YEAR (in 000's) Particulars 0 1 2 3 4 Units 500000 600000 600000 400000 Unit sale price () 10 11 12 10 Total revenue 5000 6600 7200 4000 (+) Salvage value 300 (+) Recovery of extra WC 200 (-) Machinery cost 1500 (-) Raw material cost 2500 3300 3630 2662 (-) Direct labour cost 1000 1200 1200 800 (-) Variable overhead cost 500 600 600 400 (-) Marketing expense 200 200 100 100 (-) Increase in Working capital 200 Net cash inflow/(outflow) -1700 800 1300 1670 538 Payback Period Computation Initial investment in the project = 1,700,000 Project cash inflow in the first year = 800,000 Investment recovery due after the first year = 1,700,000 - 800,000 = 900,000 Hence, time required in year 2 = (900,000/1300,000) = 0.69 years Therefore, payback period for the period = 1+ 0.69 = 1.69 years NPV computation The computation of NPV or Net Present value is estimated using a cost of capital of 12% as indicated in the tabular form below. YEAR (in 000's) Particulars 0 1 2 3 4 Units 500000 600000 600000 400000 Unit sale price () 10 11 12 10 Total revenue 5000 6600 7200 4000 (+) Salvage value 300 (+) Recovery of extra WC 200 (-) Machinery cost 1500 (-) Raw material cost 2500 3300 3630 2662 (-) Direct labour cost 1000 1200 1200 800 (-) Variable overhead cost 500 600 600 400 (-) Marketing expense 200 200 100 100 (-) Increase in Working capital 200 Net cash inflow/(outflow) -1700 800 1300 1670 538 PV factor (@ 12% pa) 1.00 0.89 0.80 0.71 0.64 PV of cash flows -1700 714 1036 1189 342 NPV () 1,581,219 Recommendation From the above discussion, it is apparent that the given company must accept the given project which is derived based on the following two decision making criteria. These are highlighted below. As per the given details the payback period required by the company on new capital projects is three years, however for the given project the payback period is 1.69 years. Thus, the given project is financially feasible. Further, the NPV of the given project has comes out to be 1,581, 219. The positive value of NPV indicates creation of wealth for shareholders and is potentially beneficial for the company. From the above two arguments, it is apparent that the company should proceed with the given project (Damodaran, 2008). Significant non-financial factors The non-financial information aspects that are significant are highlighted below (Parrino an Kidwell, 2011). The underlying future rate of growth in the given segment along the level of competition that exists and to analyse whether the introduction of the new project would adversely impact the sales of the existing products of the company. Also, the capacity of the management and other executives involved must be taken into consideration as inexperienced managers may not take the decision in a proper and considerate situation. References Damodaran, A 2008, Corporate Finance, 2nd eds., Wiley Publications, London Graham, J Smart, S 2012, Introduction to corporate finance, 5th eds., South-Western Cengage Learning, Sydney Parrino, R Kidwell, D 2011, Fundamentals of Corporate Finance, 3rd eds., Wiley Publications, London Petty, JW, Titman, S, Keown, AJ, Martin, P, Martin JD Burrow, M 2015, Financial Management: Principles and Applications, 6th eds., Pearson Australia, Sydney