Financial Accounting (Capital Budgeting: Accept/Reject and Ranking Decisions) Th
ID: 2825157 • Letter: F
Question
Financial Accounting
(Capital Budgeting: Accept/Reject and Ranking Decisions)
The Virginia Publications Distribution Company (VPD) is a medium sized firm with headquarters at their central warehouse and distribution center in Washington D.C. and their forms production facilities at a plant in Annandale, Virginia. The company's primary business consists of the design and printing of forms used by the Department of Defense (DOD) although they do have some minor contracts with a few other government agencies. In addition to the actual production of the forms, they also have a contract to serve as the warehouse and distribution center for all DOD forms used both in Washington D.C. and at the various military bases throughout the world.
The company is divided into two divisions to reflect the separate contracts for forms printing as distinct from forms distribution. Although this natural separation has greatly assisted the accounting function when preparing contract bids, it has also led to some rivalry between the two divisions in competing for the limited amount of funds available each year for capital investment. In general, the capital budgeting decisions in prior years were based on the final decision of the CEO after hearing arguments, often very subjective, from the two division vice presidents. The new procedure instituted this year was to relegate this decision to a capital budgeting staff headed by the vice president for finance. This staff was to rely primarily on objective criteria in reaching their decision and the subjective arguments would be left to the division vice presidents when/if they chose to appeal the decision to the CEO.
In preparing to conduct their analysis, the capital budgeting staff first developed their estimate of the marginal cost of capital (MCC) for the firm. It was a relatively simple task to arrive at the cost of capital using a weighted average of the costs of debt and equity as derived from observed stock and bond market information along with additional input from the investment banking firm of Keating and Trump. The final estimate suggested a cost of capital of 10 percent.
The two division vice presidents have forwarded five capital budgeting projects for evaluation and possible funding. The Printing Division submitted a proposal (Project A) to upgrade the loading and unloading facilities at both company locations to increase the efficiency of transporting finished forms from the printing to the storage and distribution warehouse. They also submitted a proposal (Project B) to replace most of the printing and paper cutting machinery with the latest models. Although this equipment is fairly expensive, the primary advantage is that all of the layout work, cutting, and packaging can be controlled by one person from a single location. In addition to the greater efficiency in the use of materials, this computerized system would allow the current labor force to be reduced by 15 people.
The Distribution Division proposed three projects. The first proposal (Project C) involved an upgrade to the loading and transportation facilities and was essentially equivalent in terms of accomplished goals to Project A. Thus, the staff immediately concluded that Project A and Project C should be considered as mutually exclusive assets for the purpose of this evaluation. Finally, Projects D and E were proposed as alternative approaches to building a major addition to the distribution center. This would allow the company to own a single in-house facility and thereby discontinue leasing space in a privately owned building directly across the street from the center.
The cash flow projections for each of these five proposed projects are shown in Exhibit 1. Project B has been classified by the staff as an independent project for purposes of evaluation since it is not impacted by the acceptance or rejection of any of the other projects.
Exhibit 1
Projected Cash Flows
Year
Project A
Project B
Project C
Project D
Project E
0
($1,750,000)
($1,800,000)
($1,750,000)
($2,500,000)
($2,700,000)
1
318,633
458,154
900,000
431,700
483,000
2
318,633
458,154
675,000
431,700
483,000
3
318,633
458,154
450,000
431,700
483,000
4
318,633
458,154
275,000
431,700
483,000
5
318,633
458,154
431,700
483,000
6
318,633
431,700
483,000
7
318,633
431,700
483,000
8
318,633
431,700
483,000
9
318,633
431,700
483,000
10
318,633
431,700
483,000
Assume that you are the staff members responsible for this capital budgeting decision. Prepare a report showing all of the capital budgeting decision criteria that you feel are important and recommend a solution to the overall capital budgeting decision for the firm. Use graphs where important to demonstrate the reasons for your conclusions. To assist you in your analysis, your decision should include two distinct steps. First, do an accept/reject decision on each asset. Second, address any capital rationing and/or mutually exclusive problems.
Year
Project A
Project B
Project C
Project D
Project E
0
($1,750,000)
($1,800,000)
($1,750,000)
($2,500,000)
($2,700,000)
1
318,633
458,154
900,000
431,700
483,000
2
318,633
458,154
675,000
431,700
483,000
3
318,633
458,154
450,000
431,700
483,000
4
318,633
458,154
275,000
431,700
483,000
5
318,633
458,154
431,700
483,000
6
318,633
431,700
483,000
7
318,633
431,700
483,000
8
318,633
431,700
483,000
9
318,633
431,700
483,000
10
318,633
431,700
483,000
Explanation / Answer
Cost of capital = 10%
Cash flow per annum = $458154
PVA of $1 for 5 years @ 10 % = 3.791
Therefore total discounted cash inflow during 5 years will be
= $458154 * 3.791 = $ 1736764.
Total inflow = $ 1736764
Less : total initial outflow = $ 1800000
-----------------------------------------------------
Net Present Value= -$63235
Decision : As the NPV of Project B is negative it should not be undertaken.
2. Project A or Project C
Project A :-
Cash inflow per annum for 10 years = $ 318633
PVA of $1 for 10 years @ 10 % =6.145
Therefore total discounted cumulative cash flow = $ 1957862
Less : Initial outflow= $ 1750000
----------------------------------------------------------------------------------------
Net Present Value= $ 207862
Project C :-
Calculation of total discounted cash inflow in 4 years
Year
Cash inflow
PV of $1 @ 10
Discounted value
1
$ 900000
0.909
818100
2
$ 675000
0.826
557550
3
$ 450000
0.751
337950
4
$ 275000
0.683
187825
Total
$ 1901425
Total cash inflow =$ 1901425
Less : Total outflow = $ 1750000
----------------------------------------------
Net Present Value=$ 151425
As mentioned in the question Project A and C are mutually exclusive project and also both the projects are having different project life. Therefore the decision will be taken by EAC.
Project A = (0.10 * 207862)/ (1-(1+0.10)-
Project C = (0.10 * 151425)/ (1-(1+0.10)-4) = $ 47783
Therefore it is advisable to accept Project C as it is having higher EAC.
Project D :-
Cashflow per annum = $ 431700
PVA of $1 for 10 years = 6.145
Therefore, Total discounted cash flow = $ 2652797
Less : Initial Investment = $ 2500000
---------------------------------------------------------------------
Net Present Value = $ 152796
Project E :-
Cash flow per annum = $ 483000
PVA of $1 for 10 years = 6.145
Therefore, Total discounted cash flow = $ 2968035
Less : Initial Investment = $ 2700000
---------------------------------------------------------------------
Net Present Value = $ 268035
Decision :As the net present value of Project E is higher than Project D, Project E should be accepted.
Year
Cash inflow
PV of $1 @ 10
Discounted value
1
$ 900000
0.909
818100
2
$ 675000
0.826
557550
3
$ 450000
0.751
337950
4
$ 275000
0.683
187825
Total
$ 1901425
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