This paper outlines a capital budgeting scenario. In addition to an NPV calculation, the paper contains explanations of key capital budgeting terms and concepts.
Caledonia Products
a) When making capital budgeting decisions, Caledonia should focus on cash flows rather than accounting profits. The argument in favor of cash flows is simple -- cash flows are what drive company value, more so than economic profit. Profit can be distorted by a number of considerations that do not impact on cash flows. For example, depreciation expense is not a cash flow, but a means of accounting for the fact that the up front purchase is not on the income statement. By using cash flows, it is easier to account for the time value of money because the cash flows are represented in the time period in which they occur -- that is not always the case with accounting for economic profit.
b) Depreciation is not included in the calculation of cash flows, because it is not a cash flow. The item that depreciation represents is the initial purchase. Depreciation, does however, have an impact on cash flows. Depreciation is an expense that lowers the EBITDA. This in turn results in a decreased tax obligation. Thus, the impact of depreciation on the cash flows is encapsulated in the "depreciation tax credit" of the net present value (NPV) calculation. This represents the after-tax cash benefit of the depreciation expense associated with the project.
c) Sunk costs are irrelevant to the cash flows. When making a capital budgeting decision, it is important to remember that any money already spent cannot be recouped no matter what decision is made. The money is gone. The decision about what to do in the future is not related to decisions that were made in the past; the decision only relates to cash flows that are directly impacted by the decision at hand.
d) The project's initial outlay is $8.1 million. This consists of three components. The largest of these is the initial purchase, which is $7.9 million for the equipment. Shipping and installation accounts for a further $100,000 of the initial outlay. Lastly, $100,000 in working capital is needed to get the project off the ground. This is also included in the initial outlay because it is needed now.
e) The differential cash flows over the project's life are $47.686 million in future value. These cash flows represent the sum total of cash flows associated with the investment decision, from the initial outlay to annual flows to the terminal cash flow.
f) The terminal cash flow is the flow at the end of the project. In this case, the termination of the project comes at the end of the fifth year. Given that all revenues and costs in that year are also assumed to come at the end, the terminal cash flow used in the calculation also includes the final year revenues and costs. This gives a total final year cash flow of $7.5372 million in future value. Excluding the revenue and cost components, the terminal cash flow only includes the working capital that is liquidated upon project termination. This is $2.4 million. The equipment is not expected to have a salvage value, so liquidating the working capital is the only thing that will occur at the very end of the project.
g)
h) The net present value of this project is $29.099 million. This is calculated as follows:
Year
0
1
2
3
4
5
Initial Cost
(7,900,000)
Installation
(100,000)
Revenue
21,000,000
36,000,000
42,000,000
24,000,000
15,600,000
Variable Costs
(12,600,000)
(21,600,000)
(25,200,000)
(14,400,000)
(10,800,000)
Fixed Costs
(200,000)
(200,000)
(200,000)
(200,000)
(200,000)
Working Cap
(100,000)
(2,000,000)
(1,500,000)
(600,000)
1,800,000
2,400,000
Dep Exp Ben
537,200
537,200
537,200
537,200
537,200
FV
(8,100,000)
6,737,200
13,237,200
16,537,200
11,737,200
7,537,200
PV
(8,100,000)
5,858,435
10,009,225
10,873,477
6,710,782
3,747,320
NPV
29,099,240
d
15%
i) The project's internal rate of return is 119%. This is calculated as the return of the project at a discount rate of 0%.
j) The project should be accepted. By any measure, this is a good project for the company. It has a positive NPV, a very high IRR, and has a short payback period (early in year 2). In general, any project that has a positive NPV is one that delivers value to the shareholders, improving shareholder wealth. Thus, any project with the positive NPV should be undertaken if the company can do so. In this case, there are no known barriers to accepting this project.
k) Risk can be measured in a number of ways. The most basic measure of risk is found in the discount rate. This rate reflects a combination of the firm's risk (cost of capital) and the project's risk, which can be built into the discount rate as well. This risk is associated with the likelihood that the future cash flows will decline in value. The second way to evaluate the risk of a project is through a sensitivity analysis. This form of analysis subjects the calculation to changes in key variables, to determine what the impact of a change in those variables is. For example, this calculation changes more with a 1% change in the discount rate than it does with a 1% change in the tax rate. This indicates that the project is more sensitive to the discount rate than the tax rate. Normally, all key variables will be subject to sensitivity analysis, including cost and revenue projections. A third way of evaluating risk in a capital budgeting project is through the payback period. The longer the payback period, the higher the project's risk, because with time more different factors can influence the project. This is the same principle as sensitivity analysis and discount rate -- as circumstances can change over time the project's risk is seen to increase, therefore a project that pays back the initial investment quickly is a less risky project.
l) According to CAPM, the measure of a project's risk that is relevant is the firm's cost of capital. The cost of capital is related to the firm's risk relative to the market, so this is the most important measure, if applied to an NPV calculation as the discount rate. The most important implication for this in capital budgeting is that the project should share the firm's risk characteristics if the NPV calculation is going to use the firm's cost of capital as its discount rate. For projects that are significantly different in risk characteristic to the firm's existing risk, the discount rate is a poor measure of the project's risk. Indeed, even if the firm's risk characteristics have changed such that the beta (measure of risk vs. The broad market) is no longer applicable then the discount rate under that circumstance would also be unreliable.
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