Assignment 2 Capital Budgeting Report PDF

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Looks at the quantitative tools for decision making for capital investment programs...

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Capital Budgeting Report

Executive Summary This report aims to examine common capital budgeting methods used in evaluating profitability of projects and comparing mutually exclusive projects, while considering the time value of money. In particular, this report will apply the net present value method, internal rate of return and crossover rate, and the discounted payback period. Each method will be evaluated in terms of its effectiveness and suitability in relation to choosing to produce a powerboat with a large carbon footprint, or a powerboat considering environmental sustainability. The findings reveal that users of the capital budgeting methods abovementioned must understand the method fully to ensure that results are not misleading. Not all methods can be used to compare mutually exclusive investments, while other methods can ignore important information. Being arrogant to these facts can result in costly decisions. Furthermore, it is found that the numbers derived from correctly used capital budgeting methods can result in costly decisions and should be used in conjunction with qualitative information. It is clear that different capital budgeting methods are best suited to different scenarios. It is also clear that the obvious choice is not always the right choice. The most commonly used methods such as the IRR should be used with extreme care. The crossover rate is useful to determine at what point we may consider another project and can be used as a target and motivation to cut the cost of capital. The NPV method is cumbersome as it requires calculation of the appropriate discount rate, or cost of capital, though it is a great tool as it considers the time value of money. The discounted cash flow method is useful where the investment has a deadline by which it must be recovered and is accurate as it also considers the time value of money, but also requires calculating the relevant discount rate. The following recommendations have been made: -

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Use the internal rate of return to calculate the crossover rate to see at what cost of capital the alternative investment becomes viable and formulate potential strategies aimed at achieving this cost of capital Avoid comparing mutually exclusive investments using the internal rate of return Use the net present value method over all other methods When using the discounted payback period method, always couple it with the NPV method to avoid ignoring important information Do not make a decision based on the numbers alone. Consider the qualitative information available Look for strategies to reduce the cost of capital Consider the rate at which cash flows generated from the investment will be reinvested

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Table of Contents Executive Summary.................................................................................................................................. i List of Tables and Figures ....................................................................................................................... iii Tables ................................................................................................................................................. iii Figures ................................................................................................................................................ iii Introduction ............................................................................................................................................ 1 Findings ................................................................................................................................................... 2 Quantitative Analysis (with explanation of results) ............................................................................ 2 Net Present Value Method ............................................................................................................. 2 Internal Rate of Return Method and the Crossover Rate ............................................................... 3 Discounted Payback Period............................................................................................................. 4 Qualitative........................................................................................................................................... 5 Recommendations and Justifications ..................................................................................................... 5 Detail Comparison and Further Recommendations ............................................................................... 6 Conclusion ............................................................................................................................................... 7 References .............................................................................................................................................. 8 Appendix ................................................................................................................................................. 9 A:

Excel Raw Data ............................................................................................................................ 9

B:

Excel Raw Data – Formulas ....................................................................................................... 10

C:

Excel Cash Flow Analysis ........................................................................................................... 11

D:

Excel Cash Flow Analysis – Formulas ........................................................................................ 12

E:

Q – Payback Period ................................................................................................................... 13

F:

S – Payback Period .................................................................................................................... 13

G:

S – Discounted Payback Period 14.46% .................................................................................... 13

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List of Tables and Figures Tables Table 1:

Annual Cash Flows

Table 2:

Q – NPV

Table 3:

S – NPV

Table 4:

IRR and Crossover Rate

Table 5:

WACC & Project Return

Table 6:

Q – Payback Period

Table 7:

S – Payback Period

Table 8:

Q – Discounted Payback Period 20%

Table 9:

S – Discounted Payback Period 20%

Table 10:

Q – Discounted Payback Period 25%

Table 11:

S – Discounted Payback Period 25%

Table 12:

S – Discounted Payback Period 14.46%

Table 13:

Q & S – Detail Comparison

Figures Figure 1:

Ranking effect of WACC

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Introduction The CFO of PENTAG is looking to substantiate the financial implications of the manufacture of a new powerboat. This report aims to demonstrate the use of capital budgeting techniques by evaluating and comparing mutually exclusive projects, Q-Powerboat (Q) and S-Powerboat (S). PENTAG is considering S as a green alternative to Q and requires further information to assist in the final decision. At the request of the CFO, this report will use the information provided by PENTAG as shown in appendix A – D, to analyse the incremental cash flows for both projects using common capital budgeting methods (Swinburne University of Technology 2019?, p. 3). According to Viviers and Cohen (2011, p. 86), motor manufacturers with projects that span on average 6 years equally prefer the net present value (NPV) and internal rate of return (IRR) methods, followed by the discounted payback period (DPB). With a similar price point and project lifespan to motor vehicles, the scenario at hand and chosen methods are comparable. This report will quantify the data provided by PENTAG and apply the abovementioned criteria to both Q and S. The report will discuss qualitative aspects of Q & S and recommendations will be made and justified. Before concluding, further recommendations will be made based on a detail comparison of Q & S.

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Findings Quantitative Analysis (with explanation of results) While the weighted average cost of capital (WACC) for similar projects varies between 20%-25%, management have assigned the required rate of return (RRR) at 20% while the CFO wants to consider both 20% and 25% (Swinburne University of Technology 2019?, p. 3).

Net Present Value Method Seen in tables 2 and 3 is the NPV. NPV is the sum of the present value of all cash flows given the discount rate, in this case the WACC/RRR. The firm and shareholders expect a minimum return equal to the WACC (Kierulff 2008, p. 323). A positive NPV yields an increase in firm value today and vice versa for a negative NPV. Based off the annual cash flows alone, S yields a higher net return of $29,200,000, as table 1 suggests. However, while each scenario adds value to the firm at both WACC rates, comparing tables 2 and 3 suggest, Q has the most appealing at both rates with a best case NPV of $5,556,576 at 20% and worst case NPV of $2,558,919 at 25%. Table 1: Annual Cash Flows Q-Powerboat S-Powerboat Annual Cash Annual Cash Year: Flows Flows 0 -$21,500,000 -$21,500,000 1 $8,924,800 $6,400,000 2 $8,294,800 $7,400,000 3 $7,664,800 $7,900,000 4 $7,034,800 $8,600,000 5 $6,404,800 $9,300,000 6 $10,322,000 $11,100,000

NPV: $27,146,000 $29,200,000 Source: Adapted from Swinburne University of Technology (2019?, p. 2-3)

Table 2: Q – NPV

Year: 0 1 2 3 4 5 6 NPV:

Q-Powerboat PV of Annual PV of Annual Cash Flows @ Cash Flows @ 20% 25% -$21,500,000 -$21,500,000 $7,437,333 $7,139,840 $5,760,278 $5,308,672 $4,435,648 $3,924,378 $3,392,554 $2,881,454 $2,573,945 $2,098,725 $3,456,817 $2,705,850 $5,556,576

$2,558,919

Source: Adapted from Swinburne University of Technology (2019?, p. 2-3) Table 3: S – NPV S-Powerboat PV of Annual PV of Annual Cash Flows @ Cash Flows @ 20% 25% Year: 0 -$21,500,000 -$21,500,000 1 $5,333,333 $5,120,000 2 $5,138,889 $4,736,000 3 $4,571,759 $4,044,800 4 $4,147,377 $3,522,560 5 $3,737,461 $3,047,424 6 $3,717,368 $2,909,798

NPV: $5,146,187 $1,880,582 Source: Adapted from Swinburne University of Technology (2019?, p. 2-3)

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Internal Rate of Return Method and the Crossover Rate Table 4: IRR and Crossover Rate Year: 0 1 2 3 4 5 6 IRR:

Q-Powerboat Cash Flows $ -$ 21,500,000 $ 8,924,800 $ 8,294,800 $ 7,664,800 $ 7,034,800 $ 6,404,800 $ 10,322,000

-$ $ $ $ $ $ $

30.20%

S-Powerboat Cash Flows $ 21,500,000 6,400,000 7,400,000 7,900,000 8,600,000 9,300,000 11,100,000

(Q-S) Crossover $ $ $ 2,524,800 $ 894,800 -$ 235,200 -$ 1,565,200 -$ 2,895,200 -$ 778,000

28.42%

14.46%

Source: Adapted from Swinburne University of Technology (2019?, p. 2-3) Table 5: WACC & Project Return WACC % 0% 5.00% 10.00% 14.46% 20.00% 25.00% 28.42% 30.00% 30.20% 35.00%

Q-Powerboat NPV $ $ 27,146,000 $ 19,652,891 $ 13,835,579 $ 9,692,819 $ 5,556,576 $ 2,558,919 $ 819,727 $ 88,705 $ -$ 1,970,953

$ $ $ $ $ $ $ -$ -$ -$

S-Powerboat NPV $ 29,200,000 20,776,599 14,283,416 9,692,819 5,146,187 1,880,582 786,897 882,228 2,991,131

Preferred S-Powerboat S-Powerboat S-Powerboat Indifferent Q-Powerboat Q-Powerboat Q-Powerboat Q-Powerboat Neither Neither

Source: Adapted from Swinburne University of Technology (2019?, p. 2-3) Figure 1: Ranking effect of WACC

Equally as popular as the NPV method, is the IRR method (Viviers & Cohen 2011, p. 86). As shown in table 5, at the IRR, the present value of all future cash flows are equal to the present value of the initial outlay, or where the present value of all cash flows are equal to zero (Viviers & Cohen 2011, p. 81). Generally, an attractive investment will cost less than it returns. Table 4 shows both projects cost less than they return with the WACC less than the IRR. Due to differing periodic cash flows between the projects, the IRR cannot be reliably be used to compare two mutually exclusive projects (Kierulff 2008, p. 325). The IRR also returns false positives where there is a negative cash flow other than the initial outlay (Kierulff 2008, p. 325). This ranking problem can be addressed by looking at the crossover in table 4, the IRR at which both projects yield an equal return (Ross 2016, p. 233). Referring to table 5, a unique decision is derived where the WACC is either above or below the crossover of 14.46%. Referring to figure 1 reveals graphically, the unique decision effect the WACC has relevant to the crossover rate.

Source: Adapted from Swinburne University of Technology (2019?, p. 2-3)

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Discounted Payback Period Though one of the simplest, the PB method is frequently used by decision makers, however does not consider the time value of money (Viviers & Cohen 2011, p.82). On the other hand, the DPB method does consider the time value of money (Viviers & Cohen 2011, p.82). Results derived from the DPB method indicate whether the life of the investment outlives, or is outlived by the DPB (Viviers & Cohen 2011, p. 82). If the cash flows or investment expires before the DPB is realised, the NPV is negative, and vice versa. Referring to table 6 to 11, the DPB is not acceptable for either option at either WACC where using the PB method would result in an accept decision for either project, as shown in appendix E and F. Table 8: Q – Discounted Payback Period 20%

Table 10: Q – Discounted Payback Period 25%

Q-Powerboat @ 20% Cumulative Discounted Year Cash Flow Discounted Balance 0 -21,500,000 -21,500,000 -21,500,000 1 8,924,800 7,437,333 -14,062,667 2 8,294,800 5,760,278 -8,302,389 3 7,664,800 4,435,648 -3,866,741 4 7,034,800 3,392,554 -474,187 5 6,404,800 2,573,945 2,099,759 6 10,322,000 3,456,817 5,556,576 Discounted Payback Period in Years: 4.18

Q-Powerboat @ 25% Cumulative Discounted Year Cash Flow Discounted Balance 0 -21,500,000 -21,500,000 -21,500,000 1 8,924,800 7,139,840 -14,360,160 2 8,294,800 5,308,672 -9,051,488 3 7,664,800 3,924,378 -5,127,110 4 7,034,800 2,881,454 -2,245,656 5 6,404,800 2,098,725 -146,931 6 10,322,000 2,705,850 2,558,919 Discounted Payback Period in Years: 5.05

Source: Adapted from Swinburne University of Technology (2019?, p. 2-3)

Source: Adapted from Swinburne University of Technology (2019?, p. 2-3)

Table 9: S – Discounted Payback Period 20%

Table 11: S – Discounted Payback Period 25%

S-Powerboat @ 20% Cumulative Discounted Year Cash Flow Discounted Balance 0 -21,500,000 -21,500,000 -21,500,000 1 6,400,000 5,333,333 -16,166,667 2 7,400,000 5,138,889 -11,027,778 3 7,900,000 4,571,759 -6,456,019 4 8,600,000 4,147,377 -2,308,642 5 9,300,000 3,737,461 1,428,819 6 11,100,000 3,717,368 5,146,187 Discounted Payback Period in Years: 4.62

S-Powerboat @ 25% Cumulative Discounted Year Cash Flow Discounted Balance 0 -21,500,000 -21,500,000 -21,500,000 1 6,400,000 5,120,000 -16,380,000 2 7,400,000 4,736,000 -11,644,000 3 7,900,000 4,044,800 -7,599,200 4 8,600,000 3,522,560 -4,076,640 5 9,300,000 3,047,424 -1,029,216 6 11,100,000 2,909,798 1,880,582 Discounted Payback Period in Years: 5.35

Source: Adapted from Swinburne University of Technology (2019?, p. 2-3)

Source: Adapted from Swinburne University of Technology (2019?, p. 2-3)

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Qualitative PENTAG has identified S as a potential alternative with considerably less emissions after a negotiation by Save the Waterways (Swinburne University of Technology 2019?, p. 3). Over the 6year lifespan, revenues for Q trend downward while S trends upward. This suggests market preferences are expected to shift to greener alternatives over the 6-year lifespan. According to Wingard and Vorster (2001, p. 314), considering environmental sustainability offers easier market penetration and increased revenue and profits. Wingard and Vorster (2001, p. 317) suggest that effective marketing campaigns can lead to better acceptance of green alternatives by the market. Wingard and Vorster (2001, pp. 316-318) have also found that environmentally sustainable companies prosper through a reduced WACC. Decreasing the WACC can be achieved through lenders offering cheaper debt, less risk of noncompliance, positive public relations, better reinvestment opportunities, higher share price and increasing market share and supply chain accessibility through removing trade barriers (Wingard & Vorster 2001, pp. 314-318). PENTAG could capitalise on this to amplify the returns offered through offering environmentally sustainable products.

Recommendations and Justifications PENTAG have nominated a WACC of 20% and a DPB of 4 years. Due to differences in periodic cash flows, the IRR in raw form has issues ranking mutually exclusive investments, and for this reason, should be used with caution. The IRR method is useful as a starting point to ascertain if a project has an acceptable return by comparing a projects return rate against the firms WACC. IRR method however, is only useful for comparing two mutually exclusive investments by calculating the crossover rate. The crossover rate can be used to formulate strategies with regards to timing of buying and selling, and setting a target when working towards reducing the WACC. The NPV method will identify projects which are profitable with regard to the time value of money with comparable results for projects that are mutually exclusive. DPB will evaluate the cash flows with regard to the time value of money to ascertain how long it takes to recover the outlay. Using only the DPB method would ignore projects outside the desired timeframe where NPV method gives managers the opportunity to see the earning power of an investment past the DPB. In turn, this can give managers the motivation to improve a projects speculated return, or perhaps choose an option not too far outside the DPB. For making accept and reject decisions about mutually exclusive projects, the NPV and DPB methods should be used in conjunction with one another as they both require discounting future cash flows.

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Detail Comparison and Further Recommendations After a direct comparison of each projects information as shown in table 13, neither option can be accepted purely based on numbers alone. Investing in Q may limit PENTAG’s future reinvestment opportunities which in turn may constrain future growth. This is because the NPV and IRR assume that the cash flows will be reinvested at the rate of the project from which it was generated (Kierulff 2008, p. 323). The shift of market preference suggests investing in Q will limit future reinvestments to similar projects with high WACC and lower returns, while transitioning to a green alternative at the end of Q is likely to have a high WACC with a very tight, or possibly negative NPV. The qualitative analysis identifies S as the only viable option due to the possibility of reducing the WACC through marketing and producing a green option. Producing S and aiming to reduce the WACC equal to the crossover rate of 14.46% would result in an acceptable DPB of 4 years as shown in appendix G, table 12. The shift of market preference suggests investing in S will propose more profitable future reinvestment opportunities which are likely to consist of green tech. Furthermore, the opportunities are likely to have a lower WACC with healthy NPVs. Considering all the factors, I would recommend investing in S. Investing in green tech now will give PENTAG a competitive advantage over the competition even if the WACC of 14.45% cannot be achieved. This will place PENTAG in a better position for years ...