Capital Budgeting Decisions for a Manufacturing Company

Topic: Business Words: 855 Pages: 4 Updated: Aug 22, 2022

Summary of information provided
A statement showing incremental cash flow of the project
Payback period
Net present value
Making a decision based on the calculations above
References

Summary of information provided

The table presented below shows a summary of information that will be used in the succeeding calculations.

	Item	Value
1	Sales in the first year	$950,000
2	Sales in subsequent years	$1,500,000
3	Direct costs (labor and materials)	45% of sales
4	Indirect incremental costs	$95,000
5	New plant	$1,500,000
6	Depreciation	Straight line for 5 years
7	Additional investment in inventory and receivables	$200,000
8	Marginal tax rate	35%
9	Cost of capital	10%
10	Duration of the project	8 years

A statement showing incremental cash flow of the project

The incremental cash flow is arrived at by deducting the total cash outflow from the total cash inflow (Shapiro, 2005). The table presented below shows the computation of the incremental cash flow.

First part of the table (year 0 – 4)

Year	0	1	2	3	4
Sales		950,000	1,500,000	1,500,000	1,500,000
Cost of new plant	1,500,000
Working capital (additional net investment)	200,000
Direct cost (45% * Sales)	0	427,500	675,000	675,000	675,000
Indirect incremental costs	0	95,000	95,000	95,000	95,000
Depreciation (1,500,000/5 for each year)		300,000	300,000	300,000	300,000
Total income (Sales + release of working capital)		950,000	1,500,000	1,500,000	1,500,000
Total cost (new plant + cost of working capital + direct + indirect cost + depreciation)	1,700,000	822,500	1,070,000	1,070,000	1,070,000
Net income (Total income – total cost)	(1,700,000)	127,500	430,000	430,000	430,000
Marginal tax rate (35% * net income)		44,625	150,500	150,500	150,500
Net income after tax (Net income – marginal tax)	(1,700,000)	82,875	279,500	279,500	279,500
Net incremental Cash flow (Net income after tax + depreciation)	(1,700,000)	382,875	579,500	579,500	579,500

Continuation of the table (year 5 – 8)

Year	5	6	7	8	Total
Sales	1,500,000	1,500,000	1,500,000	1,500,000	11,450,000
Cost of new plant					1,500,000
Working capital (additional net investment)				200,000
Direct cost (45% * Sales)	675,000	675,000	675,000	675,000	5,152,500
Indirect incremental costs	95,000	95,000	95,000	95,000	760,000
Depreciation (1,500,000/5 for each year)	300,000				1,500,000
Total income (Sales + release of working capital)	1,500,000	1,500,000	1,500,000	1,700,000	11,650,000
Total cost (new plant + cost of working capital + direct + indirect cost + depreciation)	1,070,000	770,000	770,000	770,000	9,112,500
Net income (Total income – total cost)	430,000	730,000	730,000	930,000	2,537,500
Marginal tax rate (35% * net income)	150,500	255,500	255,500	325,500	1,483,125
Net income after tax (Net income – marginal tax)	279,500	474,500	474,500	604,500	1,054,375
Net incremental Cash flow (Net income after tax + depreciation)	579,500	474,500	474,500	604,500	2,554,375

The last row of the two tables shows the net incremental cash flow for each year. The total incremental cash flow for the project is $2,554,375.

Payback period

The capital decision analysis tool gives the duration of time that the business will take to recover the initial cost of investment. This tool of analysis is significant for the ranking of projects (Hansen, Mowen, & Guan, 2009). A project with a shorter payback period is often preferred.

Payback period = Net cash inflows / initial investment

= $ 4,254,375 / $1,500,000

= 2 years and 10 months

Based on the calculations, the payback period of the project is

Net present value

The net present value method will involve the selection of a rate acceptable to the management or that equals the cost of finance. The net present value is obtained by deducting the present value of cash outflow from the present value of cash inflow (Siddiqui, 2005). If the NPV is positive, the decision should be to invest in the project but if negative, the decision should be to avoid the project (Steven, 2007). The table presented below shows the calculations for the net present value.

The first part of the table (year 0 – 4)

Year	0	1	2	3	4
Net incremental Cash flow (Net income after tax + depreciation)	(1,700,000)	382,875	579,500	579,500	579,500
Discount rate 10%	1.00	0.9091	0.8264	0.7513	0.6830
*Present value (Net incremental cash flow discount rate)**	(1,700,000)	348,068.18	478,925.62	435,386.93	395,806.30
Net present value (at 10%)	1,111,351.05

Continuation of the table (year 5 – 8)

Year	5	6	7	8	Total
Net incremental Cash flow (Net income after tax + depreciation)	579,500	474,500	474,500	604,500	2,554,375
Discount rate 10%	0.6209	0.5645	0.5132	0.4665
*Present value (Net incremental cash flow discount rate)**	359,823.91	267,842.88	243,493.53	282,003.71	1,111,351.05
Net present value (at 10%)	1,111,351.05

From the calculations present above, the net present value of the new product line is $1,111,351.05.

Making a decision based on the calculations above

Based on the calculations above, the project has a shorter payback period of 2 years and 10 months than the policy of the company (3 years). Further, the project yields a positive net present value of $1,111,351.05. Thus, the project should be accepted since it yields positive returns and the investors will be able to recover the initial cost of investment within a short period (Shim, & Joel, 2008). An additional investment in land and building will affect the net present value and the payback period. If the additional investment lengthens the payback period and the NPV turns negative, then the project will no longer be financially viable.

References

Hansen, R., Mowen, M., & Guan, L. (2009). Cost management: accounting & control. USA: South Western Cengage Learning.

Shapiro, A. (2005). Capital budgeting and investment analysis. India: Pearson Education India.

Shim, J., & Joel, S. (2008). Financial management. New York: Barron’s Educational Series, Inc.

Siddiqui, A. (2005). Managerial economics and financial analysis. New Delhi: New Age International (P) Limited.

Steven, B. (2007). Financial analysis a controllers guide: Financial analysis. New York: John Wiley & Sons.