Please set-up solution model for the following capital budget problem. Explain the approach you plan to take and why. Then, please perform the calculations of your model and draw conclusions.
Capital Budget Problem:
This case continues following the new project of the WePPROMOTE Company, that you and your partner own. WePROMOTE is in the promotional materials business. The project being considered is to manufacture a very unique case for smart phones. The case is very durable, attractive and fits virtually all models of smart phone. It will also have the logo of your client, a prominent, local company and is planned to be given away at public relations events by your client.
More details have emerged and your estimates are becoming more precise.
The following are the new values to the data that you have been estimating up to this point:
- You can borrow funds from your bank at 3%.
- The cost to install the needed equipment will be $105,000 and this cost is incurred prior to any cash is received by the project.
- The gross revenues from the project will be $25,000 for year 1, then $27,000 for years 2 – 4. Year 5 will be $23,000.
- The expected annual cash outflows (current project costs) are estimated at being $13,000 for the first year, then $12,000 for years 2, 3, and 4. The final year costs will be $10,000.
- After 5 years the equipment will stop working and will be worthless.
- The discount rate you are assuming continues to be 6%.
We are going calculate the NPV with the data we have. Before we start –
- On year 0 of the project we are going to spend $105000 for the equipment and it is capital out flow that would cause increase in long term liability and increase in long term assets, we can use a liner depreciation too which will be $21000 starting year 1, in the project
Depreciation is an accounting trick which allows a business to write off the value of an long term asset over a period of time, but this is considered as a non-cash transaction (Investopedia, n.d.).
- Revenue on year 1 = $25000, years 2 – 4 = $27000 and on 5th year $23000
- Cash outflow for the project on year 1 =$13000 , years 2 – 4 = $12000 and on 5th year $10000
- There is no salvage value for the equipment after 5 years
- And the discount rate we will use is 6%, considering that the 3% bank borrowing rate is included with any inflation or other factors.
Considering all the points we can now quickly calculate the projected Operating cash for each year:
|Year 0||Year 1||Year 2||Year 3||Year 4||Year 5|
|Current project Costs||-13000||-12000||-12000||-12000||-10000|
|Operative Cash Flow||-105000||12000||15000||15000||15000||13000|
The negative numbers show cash outflow and the positive numbers are cash in flow
We have the projected future cash flow from this project, but these are future money (and of course not accurate amount, just projected amount) and we can determine what that means in present amount. But we need to calculate NPV. We can find out if we are going to profit (considering the projected cash flow) or make a loss in this project in terms of present dollars.
Now, to obtain the present value of the future cash flow we need to discount the future cash flow with 6% discount rate.
Net Present Value is the difference between the present value of all cash inflows and cash outflows over a period of time, in our case the time period for this project and NPV is used to do capital budgeting (Investopedia, n.d.).
So let us find out the NPV = (105000) + 12000 / (1+0.06) ^1 + 15000 / (1+0.06) ^2 + 15000 / (1+0.06) ^3 + 15000 / (1+0.06) ^4 + 13000 / (1+0.06) ^5 = ($43,527.59) or – $43,527.59
We can see it is a negative return, so we should not continue this project and it will not be financially beneficial.
Retrieved on 4/28/2018. Retrieved from https://www.investopedia.com/terms/d/depreciation.asp
Retrieved on 4/28/2018. Retrieved from https://www.investopedia.com/terms/n/npv.asp