Capital budget analysis of two investment projects

Capital budget analysis of two investment projects

Question

Discussion

Project A involves adding a new component to an automobile’s emissions control system. Initially available only for Ford vehicles, it will be available for other models later. Because of its potential axis, it may have to compete with new entrants who want to manufacture and sell similar products.

Project B is a special air conditioner adapter for older Ford and his GM vehicles. New vehicles from Ford and GM will have this item as standard equipment, but there will likely be an immediate market in China. Many Chinese customers want American cars, but cannot afford the full price of new models.

Answer

Axis Corporation plans to expand its business by investing in new projects to manufacture new advanced automotive spare parts. The company has two potential projects for him. One is to manufacture new components for automobile emissions control systems and the other is to manufacture air conditioning adapters for Ford and his GM vehicles. The report evaluates and analyzes both investment projects using capital budgeting and investment valuation techniques to help select the most viable investment option.

Our product staff estimates the expected demand for our products, resulting in expected sales for the next three years. In addition, it was estimated that the cost of goods sold accounted for his 60% of sales revenue. Therefore, before choosing an investment proposal among the available projects, it is necessary to evaluate and analyze the profitability and feasibility of the project. Using a straight-line depreciation estimate, a tax rate of 30%, and a discount rate of 14%, the project can be valued using the following investment valuation techniques:

Project A has an initial investment of $120,000 and an expected useful life of 3 years. Based on the estimated sales amount estimated by the production staff, the following analysis is possible.

Initial investment $      120,000
Life of the project (In years)                    3
Tax rate30%
Cost of goods sold60%
Discounting rate14%
Year0123
Sales revenue $      120,000 $      170,000 $      370,000
Cost of goods sold $      (72,000) $    (102,000) $    (222,000)
Gross profit $        48,000 $        68,000 $      148,000
Depreciation expense $      (40,000) $      (40,000) $      (40,000)
Profit before tax $          8,000 $        28,000 $      108,000
Provision for tax $        (2,400) $        (8,400) $      (32,400)
Profit after tax $          5,600 $        19,600 $        75,600
Add: Depreciation $        40,000 $        40,000 $        40,000
Cash flow generated from operations $        45,600 $        59,600 $      115,600
Initial investment $    (120,000)
Free cash flows $    (120,000) $        45,600 $        59,600 $      115,600
Discounting factor           1.0000           0.8772           0.7695           0.6750
Discounted cash flows $    (120,000) $        40,000 $        45,860 $        78,027
Cumulative cash flows $    (120,000) $      (80,000) $      (34,140) $        43,887
Fraction in years           0.4375
Net present value (NPV) $        43,887
Internal rate of return (IRR)31%
Discounted payback period               2.44
Profitability index (PI)               1.37
Accounting rate of return (ARR)61.33%

From the analysis above, we can see that Project A generates $45,600 of net cash flow from operations in its first year, with a significant increase in cash flow thereafter. We can see that Project A has an NPV of $43,887 and an internal rate of return of 31%. The discounted payback period is 2.44 years, the profitability index is 1.37, and the accounting rate of return is 61.33%.

Project B requires an initial investment of $130,000. This is based on the lifetime of the project. depreciated to zero. Estimates of expected revenue, tax rates, and discount rates allow you to perform the following analyses:

Initial investment $      130,000
Life of the project (In years)                    3
Tax rate30%
Cost of goods sold60%
Discounting rate14%
Year0123
Sales revenue $      375,000 $      130,000 $      110,000
Cost of goods sold $    (225,000) $      (78,000) $      (66,000)
Gross profit $      150,000 $        52,000 $        44,000
Depreciation expense $      (43,333) $      (43,333) $      (43,333)
Profit before tax $      106,667 $          8,667 $             667
Provision for tax $      (32,000) $        (2,600) $           (200)
Profit after tax $        74,667 $          6,067 $             467
Add: Depreciation $        43,333 $        43,333 $        43,333
Cash flow generated from operations $      118,000 $        49,400 $        43,800
Initial investment $    (130,000)
Free cash flows $    (130,000) $      118,000 $        49,400 $        43,800
Discounting factor           1.0000           0.8772           0.7695           0.6750
Discounted cash flows $    (130,000) $      103,509 $        38,012 $        29,564
Cumulative cash flows $    (130,000) $      (26,491) $        11,520 $        41,084
Fraction in years           0.6969           0.3897
Net present value (NPV) $        41,084
Internal rate of return (IRR)37%
Discounted payback period               1.70
Profitability index (PI)               1.32
Accounting rate of return (ARR)54.15%

From the above analysis, it can be seen that the cash flow generated by the operation of the project B was $118,000 in the first year, but the cash flow generation gradually decreased in the following years. The project has a net present value of $41,084 and an internal rate of return of 37%. The discount payback period for this project will be short at 1.7 years. Project B has an accounting rate of return of 54.15% and a profitability index of 1.32.

Market price of preferred stock $        115.50
Face value $        100.00
Dividend rate10%
Annual dividend $          10.00
Cost of preference share8.66%
Face value of the bond $     1,000.00
Current price of the bond $        922.87
Capital yield $          77.13
Yield to maturity8%
Present value of capital yield $          61.23
Net proceeds $        861.64
Coupon rate5%
Annual interest $          50.00
Cost of bond5.80%
Market rate8%
Risk free rate1.50%
Company 10.70
Company 20.80
Company 31.05
Company 44.00
Company 51.10
Average beta1.53
Cost of equity using CAPM13.74%
Current dividend $            2.07
Market price of the shares $          50.00
Dividend growth rate5%
Cost of equity using dividend growth model9.14%
Computation of weighted average cost of capital:
Source of capitalAmountCostWeighted cost
Debt3000005.80%3.5%
Equity and retained earnings20000013.74%5.5%
Weighted average cost of capital9.0%

From the above calculation, the company’s weighted average cost of capital is 9%. If we take the weighted average cost of capital as the required rate of return, we can conclude that his IRR for both projects is higher than the required rate of return, and his IRR for project B is higher.

Conclusions and Recommendations

From the discussion and analysis above, Project A performs better than Project A because both projects have positive NPV. We can conclude that it is possible. Project B has a higher internal rate of return and a shorter payback period, but Project A leads to higher capital accumulation than Project B. Therefore, we recommend that you select Project A for investment.

References

Alkaraan, Fadi. “Prospects for Strategic Investment Decisions.” M&A Progress 14 (2015): 53-66.

Baum, Andrew E., Neil Crosby. Valuation of real estate investment. John Wiley & Sons, 2014.

Harris, Elaine. Strategic project risk assessment and management. Routledge, 2017.

Nadkarni, G.A “Investment evaluation for industrial enterprises” (2016).

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