Budgeting problems and Monitoring

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It is mandatory to uncover the nature or financial stability of a project that are identified by management before they are embarked on. Capital Budgeting techniques are the methods required to determine the financial viability of such projects. Three main techniques are considered – Net Pre-set Value (NPV), Internal Rate of Return (IRR) and the Payback period ("Capital Budgeting: Capital Budgeting Decision Tools", 2017).
Net Present Value (NPV) and the Payback period are elaborated on later in the study. At this point, the Internal Rate of Return is discussed to help shed more light on the techniques.

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) refers to the discount rate that occurs when the project is at the break even point, i.e. when the net present value equals zero. For investors, it is always recommended to select projects that have an IRR greater than the cost of capital. It is however not calculated in the paper.

Financial Information for Hot New Café

Expected sales for first 5 years = $800,000
Direct costs (including labor and materials) = $400,000 (50% sales)
Indirect costs = $100,000 per year
Costs for building café = $750,000
Marginal tax rate = 37%
Cost of capital = 12%

Question 1a): Calculate the payback period

Payback period = cash outlay (investment) / annual cash flow
Total investment = (cost of building)= 750,000
Annual net cash inflow= (total sales) – (direct costs + indirect costs)
= ((800,000 x 5) – (500,000 + 400,000)) / 5 = 620,000 = 620,000
Payback period = 750,000 / 620,000 = 1.21 years

Question 1b): Calculate the Net Present Value

Total revenue for the 5 years = (800,000) x 5 = 4,000,000
Total costs for the 5 years = (direct costs + indirect costs + building costs)
= 900,000 + 750,000 = 1,650,000
Before tax cash net flows = 4,000,000 – 900,000 = 3,100,000
Marginal tax = 37% = 1,147,000
After tax cash flow = 3,100,000 – 1,147,000 = 1,953,000
Net present value = Net cash inflow – initial outlay
= 1,953,000 – 750,000 = 1,203,000

Question 2) Based on the values of the Net Present Value and Payback period:

a) Should the project be accepted?

Yes, the project should be accepted as it has a payback period of only 1 year and 2 months and has a positive net present value after the five years.

b) Define and describe the Net Present Value as it pertains to the new cafe

Kurt (2017) defines NPV as the difference between the present value of cash inflows and the present value of cash outflows. It is given by the formula:

budgeting problems and monitoring
where Ct is the net cash inflow during period t, Co is the total investment costs, r the discount rate and t the number of time periods.
In regard to the new café, the value of NPV is positive thus indicating that the investment will be profitable. The value, 1,203,000 calculated shows that after the five-year period, profit of the said value will be obtained.

c. Define payback period. Assume the company has a payback policy of not accepting projects with life of over 3 years. Should the project be accepted?

EduPristine (2017) defines it as the period required by a proposal to generate cash required to recover its initial investment. It is given by the formula:
Payback period = cash outlay (investment) / annual cash flow
Yes, the project should be accepted as it indicates a payback period of only 1.2 years which is less than the requirement set by the policy.

Conclusion

The use of the capital budgeting techniques has been fundamental in illustrating the viability of the project. It is recommended that the project team implements the project as illustrated by the capital budgeting techniques.

References:

Capital Budgeting: Capital Budgeting Decision Tools. (2017). Investopedia. Retrieved 8 June 2017, from http://www.investopedia.com/university/capital-budgeting/decision-tools.asp
EduPristine. (2017). Capital Budgeting Techniques, Importance and Example. EduPristine blog on CFA, Financial Modelling, Digital Marketing, Business Analytics and Big Data. Retrieved 6 June 2017, from http://www.edupristine.com/blog/capital-budgeting-techniques
Kurt, D. (2017). Net Present Value - NPV. Investopedia. Retrieved 6 June 2017, from http://www.investopedia.com/terms/n/npv.asp

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