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Capital Budgeting Essay

1563 words - 7 pages

Capital Budgeting
1. Critical profitability analysis (Exhibit 1).Additional shortcomings omitted by Faulkner
Poor capital-budgeting decisions can be harmful to the Sugar Lake Refining and Processing Company as it will involve spending large amounts money to be recovered for a long time. Edwards & Ivancevich, (2011) demonstrate that the other harm would be the opportunity cost arising from not taking the opportunity and it turns that a competitor comes in. The worst effect is when poor budgeting decision is made and the firm ends up losing all or part of the invested monies simply because the proposed project did not realize the expected benefits. This can be demonstrated by concerns ...view middle of the document...

The arguments behind buying a new equipment worth $100,000 does not stop with the cost. Replacement decisions should also consider factors such as efficiency with a bias to more efficient equipment due to improvement in technology. Questions like would the new equipment realize reduced running costs in energy and man power as well as their possible lifespan (pp.279-281).
2. Incremental cash flows for each of the five years of the project’s life.
New Old Incremental
($) ($) ($)
Sales 43,500,000 25,000,000 23,500,000
Costs;
Marketing 1,333,500 437,500 896,000
Variable costs 58.4 *435,000 60.00* 250k 10,404,000
Rental 325,000*5 100,000*5 1,125,000
Other 300,000*5 50,000*5 1,250,000
Depreciation 657,500 25,000 632,500
Total Costs 30,520,000 15,775,000 14,745,000
Taxable Income 12,980,000 9,225,000 3,755,000
Tax (40%) 5,192,000 3,690,000 1,502,000
Net Income 7,788,000 5,535,000 2,253,000
Depreciation 131,500 5,000 126,500
Net Cash Flow 7,656,500 5,530,000 2,126,500

Notes to Accounts
* New sales revenue represented by ($6+7.5+10+20M (from other 2 years)=43,500,000
* Variable cost Old $300 (60 x 5)
* Taxable income =New sales-New total costs: Old sales –old total costs

3. Opinion on use of the payback period by Butler – (other criteria that might be more helpful).
Payback period (PBP) method only considers the time it takes for the total net cash inflows in a proposed project to equal the initial cash invested. Edwards & Ivancevich (2011) show that PBP also considers the useful life of equipment in the sense that even if the annual net cash flows would continue after the useful life of an equipment or machinery the company should not go ahead in purchasing new equipment in order to replace the old ones. While using the PBP analysis investments with shorter PBP are selected in other firms selection is restricted to projects that have PBP of less than a specified period represented by number of years.PBP analysis has a disadvantage in that it fails to consider time period beyond the payback period. For our firm the method completely ignores the revenues of $10,000 which are realized from the third year onwards. The method also ignores the time value of money, In the event of two or more competing project proposals with the same PBP but different cash inflows the project with the project with higher cash inflows in the earlier years should be selected (p.283).
Other criteria for capital budgeting as explained by Edwards & Ivancevich (2011) include Unadjusted rate of return. Unadjusted rate of return is proffered to PBP because it uses annual income rather than net cash inflows and is computed by dividing the average annual income after tax by the average amount of investment. Investment decisions are made depending on the rate of return with proposals with higher rate being preferred.Net Present Value (NPV) criteria applies a firms required rate of...

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