Design your own Capital Investment Financial Analysis problem, with all four ste

Question

Design your own Capital Investment Financial Analysis problem, with all four steps included. The steps the text shows as capital decision making process are: 1. generation of project information, 2. evaluation of projects (solvency & costs), 3. decisions about which projects to fund, 4. project implementation & reporting

Please provide your own scenario or choice for the type of project, sample data, % for the cost of capital, and calculation of Net Present Value. After calculating the NPV, provide your recommendation as to whether the project should be undertaken or not and why.

Explanation / Answer

Capital investment is the investment of money in long term project. Usually funds are employed at the begining of the project life. Then it provdes services for a specific period. It generates infloows of fund. After a specified period project comes to an end.

In capital investment usually firm has many alternative options. It has to select the best one. Suppose company wants to manufacture a product. It can be undertaken by using three different machine. Duration of each machine is three years. Company has to decide the best one for investment. It is a capital investment decision. This decision is divided into two parts;
1. Accept/reject decision and

2. Ranking decisions

In accept reject decision firm has to decide whether three machines are acceptable for investment or not. Suppose two pf them are found acceptable. Third one is rejected.

From accepted options, now firm has to decide which one is the best one. It is carried out in ranking decision.

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At the time of taking capital investment decion

1. Identification of investment opportunity

2. Generation of information

3. Evaluation of the project

4. Selection of project

5. Project implementation and reporting

Alle these steps are discussed in brief>

1. Identification of opportunities: Many ideas will continuously flow in the business. All of them are not considered. Some ideas are good in theory but not suitable for implementation. So they are to be rejected. There may be an idea to produce chemical which can provide high return to the concern. But it will generate huge quantity of obnoxiuos gas. Hence not acceptable.Acceptance of this idea will mean violation of government guidelines on pollution and will be subject to huge punishment. Hence the idea is rejected. Thus first step will be to asceretain feasibility of an idea. If it is found technically, economically and financially feasible, the only firm will move to next step.

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2. Next step is generation of project information. all relevant information required for evaluation and taking decisions should be collected. Techniques of market survey cvan be used. It is particlarly effective for a new idea which will be implemented for the first time and thus no data are available. For other projects relevant data are to be collected. In capital budgeting decision perhaps most significant information is ascertainment of cash flow data. Consider a hypothetical project X of thrree years life. Following information are collected on it for analysis and decision purpose.

a. Initial investment required: $10,000. Money required can be collected by taking loan frombank at 10% interest.

b. The amount will be used for buying a machine X. It will render service for three years. after this period it is sealable in the market at scrap value of $1,000.

c. Also there is a need for working capital of $5,000 which will be recoverred in fuill after three years.

d. The machine will generate production of 3,000; 4,000 and 5,000 units in the next three years. Produced goods can be sold at $10 per unit.

e. Manufacturing of these product will require mateial cost of $3 per unit; labor cost of $2 and other expenses of $1 per unit.

These information are collected for the project. Firm has to evaluate now by using suitable techniques.

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3. Third step is evaluation of the project. Differrent techniques are available for evaluation of project and taking appropriate decision. Firm will select a technique which has the following features:

1. Simple and easily understandable.

2. Requires minimum time to arrive at the decision.

3.Cost of taking decision should be as low as is possible

4. It must consider relevant data of the entire project life. Decision taken on the basis of partial data is not a ratoonal technique.

5. finally most crucial aspect is time value of money.

Some importantb techniques available are: pay back method, Accounting rate of return method, net present value method and internal rate of return method.

Among these techniques the firm here will not consider pay back method. It does not satisfy point 4 and 5 of a good technique as stated above. Accounting rate of return is based on average return/profit expected from the project. Data available here are showing cash flow expected from this project. So firm will not use this technique also. Other two techniques are rational and fulfill all the criterias stated above. But NPV is a little easy to implement. Hence firm may decide to evaluate it on the basis of NPV technique.

Follwing steps are required in NPV method.

Step1: Calculation of cash flows. It is shown in the table below:

Note that depereciation has been deducted first before calculating tax. Then again it is added. It is necessary since no cash outflow is taking place against deptreciation. Also in third year two other cash inflows will generate. They are salavage value $1,000 of machine and working capital recovered of $5,000. Thus cash flow of year 3 will be $20,600+$1,000+$5,000=26,600.

Step2: After calculating cash inflow now decide the minimum return required to recover dues of fund supplier. It is known as cost of capital. Here 10% interest is payable to bank against loan taken. For working capital no extra cost is needed It is free cash available in business. Since interest is paid on loan money firm will save 20% tax on interest amount. Thus effective cost of loan taken will be 10(1-0.2)=8%. It is the cost of capital used for funding the project. It is also known as cut off rate which the project must earn to become acceptable.

Step3:Now use cost of capital rate to adcertain present value of cash flow. Calculation of present value will mean time factor has been taken care off. Allcash flows of future years are now converted to the value of time t0. This calculation is shown below,

Step4; Finally deduct outflows at time t0 to get NPV. Initial cash outflow are cost of machine plus working capital . Total is $10,000+$5,000= $15,000. Thus NPV is $46,997-$15,000=$31,997

Thus evaluation process is over.

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Next step is decision making. A project will be accepted if NPV is positive. If it positive then project will give a return something more than cost of capital. Thus it will help the concern in adding valiue to the firm. Here NOV=$31,997 is positive. So project is accepted for implementation.

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After its acceptance instriuctions will come frrom higher management to line functioning areas for its implementation. It will go through the follwing process:

a. First finance department will collect fund as required. It will be remembered that cost of fund taken for this project must not be more than 8% otherwise project decision may change. Lower cost of funding if possible is always acceptable.

b.. Now planning department has to plan for its iimplementation. It includes procurement, installation and commencement of production.

c. Next purchase department will go throiugh the process of their procurement as per reports of materials prepared by planning department.

d. After procurement, Work supervisor will take steps to install machine and will commence production.

e. On succesful production it is the responsibility of sales department to market the product successfuly to realize desired cash inflows.

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Last steps is repirting. All development will be reported from line managers to higher authorities. They will carefully supervise the implementation of project as per plan. Deviations if any will be analysed causewise and appropriate steps are taken for their correction. If all these detailed procedures are follwed properly business will suceed in implementing capital investment project to achive its ultimate objective of value addition.

Year 1 Year 2 Year 3 Total 1. Production/sale in units 3,000 4,000 5,000 12,000 2. Sale value [1x$10] $30,000 $40,000 $50,000 $120,000 3. Material cost [1x$3] $9,000 $12,000 $15,000 $36,000 4. Labor cost [1x $1] $3,000 $4,000 $5,000 $12,000 5. Other expenses [1x$1] $3,000 $4,000 $5,000 $12,000 6. Depreciation[$10,000-$1,000]/3 $3,000 $3,000 $3,000 $9,000 7. Total cash outflow [3+4+5+6] $18,000 $23,000 $28,000 $69,000 8. Net cash inflow [2-7] $12,000 $17,000 $22,000 $51,000 9. Tax paid [20%on 8] $2,400 $3,400 $4,400 $10,200 10. Net cash flow after tax [8-9] $9,600 $13,600 $17,600 $40,800 11. Actual Cash inflow [10+6] $12,600 $16,600 $20,600 $49,800

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