Budgeting Fina 425 Week 5 Spring 2020 Prof David Mil

Budgetingfina425 2001a 02aiu Week 5spring 2020prof David Milneprobl

Consider the following financial aspects of a new café project: expected sales, costs, depreciation, tax rate, and capital cost. Prepare a capital budget including net cash flows over 5 years, calculate payback period and net present value, and analyze whether the project should be accepted based on these metrics. Also, define key terms related to capital budgeting, especially NPV, and discuss the project viability considering the company's payback policy of 3 years.

Paper For Above instruction

Introduction

Capital budgeting is a crucial process in financial management that enables firms to evaluate potential investment projects and determine their viability based on expected cash flows, profitability, and risk. It involves analyzing long-term investments like the proposed construction of a new café, which demands careful consideration of initial costs, operational cash flows, and financial returns. Understanding key terms such as net present value (NPV), payback period, and cash flow is essential for making informed decisions that align with strategic objectives and financial constraints.

Overview of the Proposed Café Project

The Hot New Café plans to expand its operations by constructing a new facility with an estimated initial investment of $850,000. The project anticipates consistent sales revenue of $800,000 annually over five years. Direct costs, including labor and materials, are projected at 50% of sales, amounting to $400,000 annually. Indirect operating costs are estimated at $200,000 per year. The building's depreciation is calculated on a straight-line basis over five years, resulting in an annual depreciation expense of $170,000 ($850,000 / 5). The firm's marginal tax rate is 38%, and its cost of capital is 10%, which will be used to discount future cash flows for NPV calculation.

Development of the Capital Budget

The capital budget starts with calculating the initial investment, which comprises the building cost and additional working capital if any. For simplicity, the primary focus remains on the building cost of $850,000. Then, incremental operating cash flows are determined by adjusting operating income for depreciation and taxes, following the formula:

Operating Cash Flow = Earnings Before Interest and Taxes (EBIT) + Depreciation - Taxes.

Annual revenues and costs provide the basis to calculate EBIT:

  • Sales: $800,000
  • Direct costs (50%): $400,000
  • Indirect costs: $200,000

EBIT = Sales - Direct costs - Indirect costs = $800,000 - $400,000 - $200,000 = $200,000.

Depreciation expense is $170,000 annually. Tax on EBIT is calculated as EBIT multiplied by the tax rate of 38%: $200,000 x 0.38 = $76,000. Therefore, net income after tax is EBIT minus taxes: $200,000 - $76,000 = $124,000. To find the net operating cash flow, add back depreciation: $124,000 + $170,000 = $294,000 annually.

Cash flows over the 5-year period are assumed to be uniform, given the project's steady revenues and costs. These cash flows are then discounted at the cost of capital (10%) to calculate NPV.

NPV Calculation and Interpretation

The NPV of the project is the sum of discounted cash inflows minus the initial investment. Using the present value of an annuity formula, the present value of these cash flows over 5 years at 10% is:

PV = Cash Flow x [(1 - (1 + r)^-n) / r]

Where:

  • Cash Flow = $294,000
  • r = 0.10 (10%)
  • n = 5 years

Calculating:

PV = $294,000 x [(1 - (1 + 0.10)^-5) / 0.10] = $294,000 x 3.7908 ≈ $1,114,515

Subtracting initial investment: $850,000, the project’s NPV is approximately $264,515. A positive NPV indicates the project is financially attractive and adds value to the firm.

Payback Period Analysis

The payback period is calculated by dividing the initial investment by the annual cash flow: $850,000 / $294,000 ≈ 2.89 years. Since the company's policy restricts acceptance of projects with a payback period exceeding 3 years, this project meets the policy criterion.

Decision-Making and Recommendations

Based on the NPV, which is positive, the project is financially viable and should be accepted. It demonstrates that the investment is expected to generate returns exceeding the cost of capital and adds value to the company. Additionally, the payback period of approximately 2.89 years complies with the firm's policy of not accepting projects exceeding 3 years, further supporting approval.

Understanding Net Present Value (NPV)

NPV is a financial metric that measures the difference between the present value of cash inflows and outflows over a project's lifespan. It incorporates the time value of money, discounting future cash flows at the firm's required rate of return (cost of capital). An NPV greater than zero signifies that the project is expected to generate more wealth than it costs, thereby making it a desirable investment. In the context of the new cafe, a positive NPV confirms that the expansion will likely enhance shareholder value.

Conclusion

In conclusion, the capital budgeting analysis indicates that the proposed café project is financially justifiable, given the positive NPV and acceptable payback period. These financial metrics demonstrate that the project aligns with strategic growth objectives and risk management policies. Proper evaluation using detailed cash flow analysis and discounting methods is vital for sound investment decisions in capital budgeting, ensuring the firm invests in projects that maximize value and support sustainable growth.

References

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