Capital Budgeting Analysis of Two Investment Projects

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Project a Involves Adding a New Component To The Car’s Emission Control System. At First It Will Only Be Available For Ford Automobiles And Then It Will Be Available For Other Models. Because Of Its Potential Axis May Have To Compete With New Entrants Seeking To Manufacture And Market a Similar Product.

Project b Is a Special Air Conditioning Adapter For Older Ford And Gm Automobiles. It Will Have An Immediate Market In China, Although New Ford And Gm Cars Will Come With This Item As Standard Equipment. Many Chinese Customers Desire American Automobiles But Cannot Afford The Sticker Price On Newer Models.

Axis Corporation is planning for business expansion with investment in new projects manufacturing new and advanced spares for motor vehicle. The company is having two potential projects to be opted one is manufacturing of a new component to the emission control system of cars and the other is the manufacturing of air conditioning adaptor for the Ford and GM automobiles. In this report both the investment projects have been evaluated and analyzed with the help capital budgeting and investment appraisal techniques to help in selecting the most feasible investment option.

Product staff of the company have estimated the expected demand for the products and revenue arising from them for the next three years. It has been further estimated that, cost of goods sold would be 60% of the sales revenue. Therefore, before selecting an investment proposal from the available projects, the profitability and feasibility of the projects must be evaluated and analyzed. With the estimation of straight line depreciation, 30% tax rate and 14% discounting rate, following investment appraisal techniques can be applied for evaluation of the projects.

Project A requires and initial investment of $120,000 with and expected life of 3 years. With the expected sales revenue as estimated by the production staff, following analysis can be made.

Initial investment	$ 120,000
Life of the project (In years)	3
Tax rate	30%
Cost of goods sold	60%
Discounting rate	14%

Year	0	1	2	3
Sales revenue		$ 120,000	$ 170,000	$ 370,000
Cost of goods sold		$ (72,000)	$ (102,000)	$ (222,000)
Gross profit		$ 48,000	$ 68,000	$ 148,000
Depreciation expense		$ (40,000)	$ (40,000)	$ (40,000)
Profit before tax		$ 8,000	$ 28,000	$ 108,000
Provision for tax		$ (2,400)	$ (8,400)	$ (32,400)
Profit after tax		$ 5,600	$ 19,600	$ 75,600
Add: Depreciation		$ 40,000	$ 40,000	$ 40,000
Cash flow generated from operations		$ 45,600	$ 59,600	$ 115,600
Initial investment	$ (120,000)
Free cash flows	$ (120,000)	$ 45,600	$ 59,600	$ 115,600
Discounting factor	1.0000	0.8772	0.7695	0.6750
Discounted cash flows	$ (120,000)	$ 40,000	$ 45,860	$ 78,027
Cumulative cash flows	$ (120,000)	$ (80,000)	$ (34,140)	$ 43,887
Fraction in years				0.4375

Net present value (NPV)	$ 43,887
Internal rate of return (IRR)	31%
Discounted payback period	2.44
Profitability index (PI)	1.37
Accounting rate of return (ARR)	61.33%

It can be observed from the above analysis that, project A is having a net cash generated from operation of $45,600 in the first year and thereafter a significant increase in cash flow can be observed. It can be observed that the net present value of the project A is $43,887 and the internal rate of return is 31%. The discounted payback period is 2.44 years and it is having a profitability index of 1.37 with an accounting rate of return of 61.33%.

Project B requires and initial investment of $130,000 which will be depreciated to zero over the life of the project. With the estimation of expected sales revenue, tax rate and discounting rate, following analysis can be made.

Initial investment	$ 130,000
Life of the project (In years)	3
Tax rate	30%
Cost of goods sold	60%
Discounting rate	14%

Year	0	1	2	3
Sales revenue		$ 375,000	$ 130,000	$ 110,000
Cost of goods sold		$ (225,000)	$ (78,000)	$ (66,000)
Gross profit		$ 150,000	$ 52,000	$ 44,000
Depreciation expense		$ (43,333)	$ (43,333)	$ (43,333)
Profit before tax		$ 106,667	$ 8,667	$ 667
Provision for tax		$ (32,000)	$ (2,600)	$ (200)
Profit after tax		$ 74,667	$ 6,067	$ 467
Add: Depreciation		$ 43,333	$ 43,333	$ 43,333
Cash flow generated from operations		$ 118,000	$ 49,400	$ 43,800
Initial investment	$ (130,000)
Free cash flows	$ (130,000)	$ 118,000	$ 49,400	$ 43,800
Discounting factor	1.0000	0.8772	0.7695	0.6750
Discounted cash flows	$ (130,000)	$ 103,509	$ 38,012	$ 29,564
Cumulative cash flows	$ (130,000)	$ (26,491)	$ 11,520	$ 41,084
Fraction in years			0.6969	0.3897

Net present value (NPV)	$ 41,084
Internal rate of return (IRR)	37%
Discounted payback period	1.70
Profitability index (PI)	1.32
Accounting rate of return (ARR)	54.15%

From the above analysis, it can be observed that the cash flow generated from operation for the project B $118,000 in the first year and there is a gradual decrease in the cash generation in the subsequent years. The project is having a net present value of $41,084 and an internal rate of return 37%. The project is having a lower discounted payback period of 1.7 years. The accounting rate of return for the project B is 54.15% with a profitability index of 1.32.

Market price of preferred stock	$ 115.50
Face value	$ 100.00
Dividend rate	10%
Annual dividend	$ 10.00
Cost of preference share	8.66%

Face value of the bond	$ 1,000.00
Current price of the bond	$ 922.87
Capital yield	$ 77.13
Yield to maturity	8%
Present value of capital yield	$ 61.23
Net proceeds	$ 861.64
Coupon rate	5%
Annual interest	$ 50.00
Cost of bond	5.80%

Market rate	8%
Risk free rate	1.50%
Company 1	0.70
Company 2	0.80
Company 3	1.05
Company 4	4.00
Company 5	1.10
Average beta	1.53
Cost of equity using CAPM	13.74%

Current dividend	$ 2.07
Market price of the shares	$ 50.00
Dividend growth rate	5%
Cost of equity using dividend growth model	9.14%

Computation of weighted average cost of capital:

Source of capital	Amount	Cost	Weighted cost
Debt	300000	5.80%	3.5%
Equity and retained earnings	200000	13.74%	5.5%
Weighted average cost of capital			9.0%

From the above calculations, it can be observed that, the company is having a weighted average cost of capital of 9%. If the weighted average cost of capital is considered as the required rate then it can be concluded that both the projects are having an internal rate of return higher than their required rate and the project B is having higher internal rate of return.

Conclusion and Recommendation

From the above discussion and analysis, it can be concluded that, thou both the project is having a positive net present value, project A is more feasible than the project B having a higher net present value. Though the internal rate of return is higher for the project B and the payback period is also lower, the project A will cause more capital accumulation than the project B. Hence, it can be recommended to select the project A for the investment.

References

Alkaraan, Fadi. "Strategic investment decision-making perspectives." Advances in mergers and acquisitions 14 (2015): 53-66.

Baum, Andrew E., and Neil Crosby. Property investment appraisal. John Wiley & Sons, 2014.

Harris, Elaine. Strategic project risk appraisal and management. Routledge, 2017.

Nadkarni, G. A. "Investment appraisal in industrial undertakings." (2016).

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