Capital Budgeting Financial Evaluation: JBMW
The Jones Brothers marble works is currently in the search for undertaking expansion and building new profits and revenue generating assets to take advantage of the opportunities available in the market. They have opportunities to expend in the same line of business or they can also consider expanding into other sectors for diversification and grow market elsewhere in some other sectors. Current l the company has no cash flow issues and the current business is running well and this is the right time to expand into new business opportunities and establish new lines of revenue generation.
The capital budgeting and financial evaluation of the project has been done as per the followings and the same is shown here below:
- The estimation of the Pay back period (PBP) is shown as follows:
|cash flow||cum Cash Flow|
Payback period = 1 Year + (109,050/162,450) = 1+ .67128 = 1.67128
This means the project would be able to recover all the initial investments in about 1.67 years and thus this shows a profitable investing opportunity for the Jones brother marble works.
- The Estimation of the Net present Value (NPV) is done as follows:
|initial Investment - building ||-140,000|
|initial Investment - Equipment ||-70,000|
|Working Capital -inventory ||-30,000|
|Revenue -hotel ||100,000||150,000||250,000||600,000||600,000||600,000||600,000||600,000||600,000||600,000|
|Revenue-External Range ||300,000||300,000||300,000||300,000||300,000||300,000||300,000||300,000||300,000||300,000|
|Total Revenue ||450,000||500,000||600,000||950,000||950,000||950,000||950,000||950,000||950,000||950,000|
|Administrative costs ||30,000||30,000||30,000||30,000||30,000||30,000||30,000||30,000||30,000||30,000|
|Factory Expenses -internal ||10,000||15,000||25,000||60,000||60,000||60,000||60,000||60,000||60,000||60,000|
|Factory Expenses -pots /external ||70,000||70,000||70,000||70,000||70,000||70,000||70,000||70,000||70,000||70,000|
|increased wages ||120,000||120,000||120,000||180,000||180,000||180,000||180,000||180,000||180,000||180,000|
|Depreciation- Equipment ||9,500||9,500||9,500||9,500||9,500||9,500||9,500||0||0||0|
|Depreciation - Building ||14,000||14,000||14,000||14,000||14,000||14,000||14,000||14,000||14,000||14,000|
|interest Expenses ||18,000||18,000||18,000||18,000||18,000||18,000||18,000||18,000||18,000||18,000|
|total Expenses ||296,500||301,500||311,500||401,500||401,500||401,500||401,500||392,000||392,000||392,000|
|Profit Before tax ||153,500||198,500||288,500||548,500||548,500||548,500||548,500||558,000||558,000||558,000|
|less: Tax @ 30%||46,050||59,550||86,550||164,550||164,550||164,550||164,550||167,400||167,400||167,400|
|Profit After Taxes||107,450||138,950||201,950||383,950||383,950||383,950||383,950||390,600||390,600||390,600|
|Scrap Realized ||3,500|
|Inventory Realized ||30,000|
|Cash Flows ||-240,000||130,950||162,450||225,450||407,450||407,450||407,450||407,450||404,600||404,600||438,100|
|Present Value factor @ 20%||1.000||0.833||0.694||0.579||0.482||0.402||0.335||0.279||0.233||0.194||0.162|
|Present Value @ 20%||-240,000||109,125||112,813||130,469||196,494||163,745||136,454||113,712||94,097||78,414||70,756|
As can be seen from the above estimation the NPV of the project is a positive NPV at $966,078 after discounting the cash flows at 20% rate of return. This means if the Jones broths marbles works implements this project the present value or market value of the company would be expected to improve by $966,078. Thus it is recommended to the management of the firm to undertake the project without an further delay as the opportunity might be diluted by some others working in the market and taking advantage.
- The Estimation of the Internal Rate of Return (IRR) is done as follows:
The IRR of a project is a rate of return which would make the net present value equal to zero if discounted at the IRR. This means the rate of discounting to be used would be IRR. As the 20% rate fixed by the jone’s brother company is yielding a positive NPV the same is on the lower side than the IRR. For a decision making purpose if the company finds the IRR to be higher than r , the project would be recommended for investment by the company and if the company finds the IRR to be lower than the r , the project would be rejected (BERK & DEMARZO, 2016).
The IRR of the current project is found to be 81.90%
Thus, the project is recommended for investment for the following reasons:
- The IRR > r (81.90% > 20%), which means the actual return form the investing is expected to generate a return of and the same is much higher than 20% return generally expected by the management.
- As the investment is expected to generate a higher return than what is expected by the management the same is given a go ahead as the same would add value for the firms shareholders (Eugene Brigham & Michael Ehrhardt, 2010).
Considering the three different criteria’s the project is given a go-ahead as follows:
- The payback period of the project which is currently 1.67 years is much lower than the projects life period and thus the project would be expected not to face an cash flow recovery issue.
- The NPV of the project is positive at $966,078 and the same would increase the market value of the company by $966,078.
- The project would also be expected to increase shareholders wealth as the projects IRR is greater than r.
- Thus all the financial evaluation method aggress on the implementability of the project and the same would improve the firms value (Damodaran, 2012).
For the estimation of the both internal and external project the following assumptions ha been used:
- The Research cost of $75,000 paid is ignored as it is not related to the project and is merely a sunk cost.
- Further the Building has been depreciated over the 10 years period ad as a result of which rate of depreciation used is 10%. (100/10).
- Equipment’s have been depreciated in 7 years after taking into consideration the scrap value of $3,500 in the tenth year.
- The value of the land used is not used as the land is not depreciable and after 10 ears of use the same can be sold at a higher value and hence it has no opportunity cost of being used.
2& 3. Sensitivity Report and other factors which the Firm shall consider
The current project being considered by the management of the Jones brothers marble works is quite profitable and from the above estimations it becomes clear that if the project is implemented without delay the same is expected to add quite large value to the shareholders wealth and increase market value and increase the product portfolio of the company. Form sensitivity point of view the project is quite good:
- The payback period of the firm is 1.67 years only. This means the cash invested in the project would be expected to be recovered in less than 2 years. This is particularly pleasing as the firm is taking a minimum 10 years of project life. Thus even if the cash flows are slightly revised (both downwards and upwards) there would not be a fear of not recovering the initial investment made in the project (Brearly, 2012).
- The NPV of the Project being considered in too large at $966,078 ad the same won’t be negative unless the rate of return is set higher than the 81.90% which happens to be the IRR of the project. The r of the project being only 20%, there is very less chance of the project losing significant cash flows and thus there is enough bumper for the management to work the project out and making it a profitable project (BERK & DEMARZO, 2016).
The other factors which the management of the company ( Jones brother Marbles company) shall considered is as follows:
- The primary factor (non-financial) which shall be considered b the management is that of increasing the product portfolio, reach new market without affecting the current sales of the company.
- The increasing portfolio of the company would help in the increasing employee morale and provide a higher platform to showcase their talent and reach new markets.
- The company’s management shall also consider the current legislations regarding production and future legislative changes before implementing the project. Any probable changes in the taxation rules must also be considered.
- The management of the company shall also consider the availability of trained ad skilled manpower for undertaking the new project and the existing market for new products (Atrill, 2013).
- The capital structure of the company shall be examined to ensure the debts being considered is not going to increase leverage too much and increase the company’s financial risk. The debt-equity component shall be kept under check and expected limit all the time as any probable high leverage would-be expected to increase the discounting rate.