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Capital Budgeting Decisions for a Manufacturing Company

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.