FNAN 303 Lecture Notes - Lecture 8: Project Z, Net Present Value, Capital Budgeting
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Capital budgeting involves choosing projects that add value to the firm. The net present value (NPV), internal rate of return (IRR) and payback period methods are the most common approaches to project selection. At its core, capital budgeting is measuring an accounting of costs versus benefits. In a way, all business decisions are a series of capital budgeting decisions. Get it wrong, and you can destroy a company.
The capital budgeting tools help financial managers decide on the desirability of the projects. In the real world, however, managers sometimes will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods.
For example, consider the two mutually exclusive projects below.
| Investments | Cost | Cash Flow 1 | Cash Flow 2 |
| Project A | $ 50 | $ - | $ 100 |
| Project B | $ 50 | $ 50 | $ 25 |
According to the payback period, project B should be selected. Although both projects cost the same, project B has a payback period of one period, while project A will payback in roughly 1.5 periods.
Assuming the discount rate of 5%, NPV(A) = $41 and NPV(B) = $20.
This example illustrates the limitations of the payback period method. Even though the payback period method points to project B, the NPV method points to project A since it has more than twice the NPV value to that of project B. Yet the manager may choose project A. Why?
It may be that the project stakeholder is requesting a quicker return in cash.
For this discussion, create an example problem where two (or more) methods contradict each other. What would be the "appropriate" choice (which project would you choose)? In what cases would you not choose the "best" choice?
Can somebody help me do the analysis for this capital budgeting case study? I've got everything calculate but I know what to write for the analysis
The questions that pertain to the analysis section are to help you in how you approach the analysis and drive the narrative of the analysis.
Third and Final Section â The Decision. In the a directed case, this would include those questions that pertain directly to the decision. Make your recommendation to your audience.This section can also contain any commentary relevant to the case and decision.
Based on your computations in requirement number one, which projects should be accepted? Note: Projects Exp2015-A, Exp2015-B and Exp2015-C are mutually exclusive.
| EXP2015-A | Exp215-B | Exp2015-C | TT2015-A | BH2015-A | |
| Pay back period (years) | 3.53 years | 2.85 years | 3.77 years | 4.83 years | 2.75 years |
| Net Present Value | 527,068 | 278,826 | 1,557,757 | 316,521 | 263,743 |
| IRR | 25.26% | 20.87% | 23.21% | 16.03% | 23.93% |
| MIRR | 16.39% | 13.57% | 15.66% | 12.88% | 17.47% |
| PI | 1.7 | 1.33 | 1.60 | 1.25 | 1.36 |
Viking Freight Forwarding, LLC is a family run operation. It is owned by the Ostrem family, with the 2 Ostrem brothers and 1 sister making up the upper level management team. Tom Bertram, son-in-law of the youngest Ostrem brother, has been hired as the assistant financial vice president of the firm. His primary duties are to evaluate capital budgeting projects and other related long term projects of the operation.
Bertram is currently undertaking an analysis of five major capital budgeting projects for the coming year. All of the projects except for the Ankeny Satellite Terminal project would have the same level of risk as the other long term assets of the firm. Descriptions of the five projects are below and estimate of expected cash flows for each project is outlined in Table 1.
Project Exp2015-A: Expansion of existing facilities at Des Moines Terminal.
Viking Freight Forwarding operates primarily as a bonded freight forwarder, and thus must provide rapid delivery, on short notice, of freight temporarily stored in its bonded warehouse located on Guthrie Avenue on Des Moinesâ eastside. The terminal has six existing loading docks and this number is often insufficient for the amount of freight that must be forwarded for prompt delivery.
Because of growth in business, Viking has been unable to meet the needs of its customers on a number of occasions because of backlogs at the loading docks. Firms have begun using other freight forwarders in the area and is starting to have an effect on the revenues of the firm.
Project Exp2015-A calls for the building of an annex to the existing warehouse; the annex would provide 3 new loading docks and 5,000 square feet of additional storage space. This would take some time to construct and the amount of lost revenues would continue to mount so that the recouping the lost revenues would be spread out over a longer time period. However, the additional storage space would allow for more growth in the future.
Project Exp2015-B: Alternative expansion of existing facilities at Des Moines Terminal.
Project Exp2015-Bis to simply add 3 additional loading docks to the existing building. This would significantly reduce the construction time relative to project a so that lost revenues could be recouped faster. However, no additional storage space would be added. Project Exp2015-Bwould disrupt the current operation more and the warehouse layout would have to be reconfigured, so that the total cost of the project would be the same as Project Exp2015-A. While the cash inflows would be more rapid, the projects life would be much shorter. This solves the immediate problem but does not address the growth issue.
Project Exp2015-SAT: Build a new satellite terminal in Ankeny
Rather than expanding at the current Guthrie Avenue location, Bertram is considering building a satellite terminal in the industrial park in Ankeny which is located 6 miles from the current location. The current site in Des Moines does not have the potential for extensive expansion so he is considering this expansion in an off-site location. This is a much more expensive project and more risky in that excess capacity will be built and coordinating shipments will be more difficult
Project TT2015-A: Purchase of Three New Tractor-Trailers.
An increase in business has not only caused backlogs at the loading docks but also has forced Viking to lease tractor-trailers since they have insufficient quantity of their own. This increases the cost of transportation as well as making it difficult to do regularly scheduled maintenance on their tractor-trailers since they are being fully utilized with little down time. Project TT2015-A would alleviate this problem.
Project BH2015-A: Special equipment for handling bulk commodities.
A profitable capital investment made in 1990 to handle bulk commodities and forward them by rail would be upgraded under Project BH2015-A. This would involve the installation of a movable conveyor belt to increase rail car loading efficiency by reducing current labor costs.
| Table 1 | Mutually | Exclusive | Independent | Independent | |||||
| Project | Project | Project | Project | Project | |||||
| Exp2015-A | Exp2015-B | Exp2015-C | TT2015-A | BH2015-A | |||||
| CFo | $(750,000.00) | $(840,000.00) | $(2,600,000.00) | $(1,250,000.00) | $(720,000.00) | ||||
| 1 | $ 195,000.00 | $ 275,000.00 | $ 625,000.00 | $ 258,900.00 | $ 261,900.00 | ||||
| 2 | $ 225,000.00 | $ 295,000.00 | $ 650,000.00 | $ 258,900.00 | $ 261,900.00 | ||||
| 3 | $ 214,500.00 | $ 315,900.00 | $ 750,000.00 | $ 258,900.00 | $ 261,900.00 | ||||
| 4 | $ 216,500.00 | $ 200,000.00 | $ 750,000.00 | $ 258,900.00 | $ 261,900.00 | ||||
| 5 | $ 229,400.00 | $ 110,000.00 | $ 775,000.00 | $ 258,900.00 | $ 261,900.00 | ||||
| 6 | $ 219,400.00 | $ 90,000.00 | $ 800,000.00 | $ 258,900.00 | |||||
| 7 | $ 210,400.00 | $ 90,000.00 | $ 675,000.00 | $ 258,900.00 | |||||
| 8 | $ 205,400.00 | $ 80,000.00 | $ 650,000.00 | $ 258,900.00 | |||||
| 9 | $ 195,400.00 | $ 80,000.00 | $ 625,000.00 | $ 258,900.00 | |||||
| 10 | $ 185,400.00 | $ 70,000.00 | $ 500,000.00 | $ 258,900.00 | |||||
| Note all cash-flows are on an after tax basis. | |||||||||
The existing capital structure uses very little debt and relies mostly on retention of earnings and additional equity provided by the Ostrem family. While Bertram believes that the cost of capital could be reduced by changing the capital structure to include more debt, the current capital budget must be analyzed using the existing capital structure and the relevant component costs. See Table 2 for the cost of capital and the current capital structure.
| Table 2 | Cost of capital and capital structure | Component | |||
| weight | cost | ||||
| Present | Debt | 40% | 7% | ||
| Common Equity | 60% | 14% | |||
| Tax rate =30% |