Capital Budgeting Process: Pinto Limited
Answer
Introduction
The assignment displays the capital budgeting process for a company. Pinto Limited is considering a project to introduce a new product in the market to meet the competition posed by overseas manufacturer. The product is risky and thus the CEO wants to get the financial analysis of the project to be performed and the recommendation on if the company should go ahead with the project. The CEO provides with basic information on the investment required in the project and the production details. The project is evaluated using the capital budgeting techniques of NPV, IRR, payback period, discounted payback period and profitability index (Cole-Ingait, P., n.d.). An Excel spreadsheet with details calculations is attached along with.
Net Cash Flows Calculations
The capital budgeting projects are evaluated using the net cash flows from the project. This excludes the non cash expense from being considered. The non cash expense are the accounting entries and do not impact the net worth of the project to the company. Thus the net cash flows from the project are calculated. The cost of $25,000 spent by Pinto limited on market analysis related to the project is not considered in evaluating the project as it is the sunk cost. The cost is already incurred and is not relevant for the project because the cost will be same whatever the outcome of the analysis be (Garcia, M., n.d.).
a. Calculations of Net Income: Net income from operations is calculated for the project as follows:
| Year | ||||||
| 0 | 1 | 2 | 3 | 4 | 5 | |
| Net Income : | ||||||
| Sales Volume (in units) | 200,000 | 300,000 | 450,000 | 225,000 | 112,500 | |
| Sales price (Per unit) | 75 | 77 | 80 | 82 | 84 | |
| Sales Revenue (in $ millions) | 15,000,000 | 23,175,000 | 35,805,375 | 18,439,768 | 9,496,481 | |
| Taxable income | 9,000,000 | 13,905,000 | 21,483,225 | 11,063,861 | 5,697,888 | |
| General & Admin Expenses | 1,000,000 | 1,050,000 | 1,102,500 | 1,157,625 | 1,215,506 | |
| Depreciation | 3,000,000 | 3,000,000 | 3,000,000 | 3,000,000 | 3,000,000 | |
| Taxable income | 2,000,000 | 5,220,000 | 10,219,650 | 3,218,282 | (416,914) | |
| Taxes | 600,000 | 1,566,000 | 3,065,895 | 965,485 | 0 | |
| After-tax income | 1,400,000 | 3,654,000 | 7,153,755 | 2,252,798 | (416,914) | |
The life of the new product is assumed to be 5 years with growth and decline in sales of the units. Thus the units increase in first three year and then decline in last two years. The growth in sales of units is by 50% from last year. The after tax income is calculated after considering the depreciation expense as it provides the tax shield and saves cash outflows in form of taxes.
It has been observed that there is net loss before taxes in the 5th year. Thus no taxes have been considered for that year.
b. Net cash flows Calculations
The net cash flows from the project are calculated considering the operating cash flows as well as capital investments in the project. The net cash flows are as follows:
| Year | ||||||
| 0 | 1 | 2 | 3 | 4 | 5 | |
| Net Cash Flows: | ||||||
| capital Investment | (15,000,000) | |||||
| Net Income | 1,400,000 | 3,654,000 | 7,153,755 | 2,252,798 | (416,914) | |
| Add back Depreciation | 3,000,000 | 3,000,000 | 3,000,000 | 3,000,000 | 3,000,000 | |
| Cash Flows from operations | 4,400,000 | 6,654,000 | 10,153,755 | 5,252,798 | 2,583,086 | |
| CF due to change in net working capital | (3,000,000) | 3,000,000 | ||||
| Less: Opportunity Cost | (250,000) | (250,000) | (250,000) | (250,000) | (250,000) | |
| Net Cash Flows | (18,000,000) | 4,150,000 | 6,404,000 | 9,903,755 | 5,002,798 | 5,333,086 |
The capital investment is made up front and hence it is considered to be made at time ‘Zero’. The income/cash flows starts after a year of operations and hence at the end of year 1. The cash flows from operations are calculated by adding the back depreciation expense to the income after tax. Depreciation expense is a non cash expense and is an accounting entry. Thus is does not affect the cash flows directly (managementstudyguide.com). The project also requires the working capital investment at the beginning of the project and so they are considered at the time of zero. The working capital is recovered at the end of the project. Thus the time difference value of money is considered for working capital investments.
Opportunity cost considered in the project is the income forgone in order to proceed with the project. Pinto Limited does not take into account the land base for the project because it has its own land. The area is currently rented out for the annual rent of $250,000. If the company chooses the project it will lose the rental revenue. Hence the opportunity cost of selecting the project (Wilkinson, J., 2013).
c. Evaluation Parameters
The values parameters on which the parameters are evaluated are as follows:
| NPV | 5,234,531.8 | |
| IRR | 20.5% | |
| Payback Period | 2.75 | Years |
| Discounted Pay back period | 3.44 | Years |
| Profitability Index | 1.71 |
Analysis of the Project
The project of Pinto Limited is analyzed on the capital budgeting parameters as defined above. The cash flows are discounted at 10% which is the weighted average cost of capital of the company.
i. NPV: NPV of the project gives the net discounted cash flows of the project. The project should be accepted if NPV is positive. NPV of the project is more than $5million. This means that the project is profitable to the company.
ii. IRR: IRR is the internal rate of return. It is return provided by the project. The IRR should be more than the WACC of the company. The WACC of Pinto Limited is 10% and the IRR is the project is 20.5%. The IRR is more than WACC and thus the project will give higher to the company.
iii. Payback period: The time in which the initial investment will be recovered. The simple payback period is 2.75 years and discounted payback period is 3.44 years. The capital investment is completely recovered during the life of the project and thus the projects is feasible.
iv. Profitability Index: It is the ratio of t he PV of net cash inflows to initial investment. The index should be more than 1. The PI of the project is 1.71
Conclusion & Recommendation
It is concluded from the above analysis that the project of new product has positive NPV. The IRR is more than the WACC of the company. The payback period is less than the life of the project and the PI is more than 1. All the parameters indicate that the project is profitable and will increase the net worth of the o company.
Thus it is recommended to Pinot Limited that it should accept the new product project.
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