Capital Budgeting Analysis: Lazy Mower
The Lazy Mower: Is it Really Worth It?
Capital Budgeting Analysis: A case of Innovative Products Inc, (IPI)
Abstract
In this paper, we demonstrate the use of capital budgeting analytical tool in assessing the company's plan to invest in a project called: Lazy Mover by addressing various questions being contemplated by members of the project design team, towards evolving a convincing and detailed feasibility study to Capital Investment Committee (CIC) of IPI. This paper demonstrates necessary principles and ideologies with difficulties behind capital budgeting analysis, especially in treatment of certain components of project appraisal. IPI, being a firm currently witnessing down-turn in its revenues and profit margins shrinking due to severe price competition, Dan Conklin and Ron Howard, key members of the design team quickly realized their task at getting the approving authority on their side if their efforts will not be in futility, hence these thorough feasibility reports are put together.
Introduction
Since firms are essentially defined by its assets and products/services those assets can produce, capital budgeting is therefore crucial and germane to the survival, continuity and growth of corporate entities. Financing decisions, especially on long-term investments projects could make or mar the story of corporations, irrespective, of their sizes or market values. Hence, capital budgeting, being process of choosing the firm's long term capital investment is always given a lot of considerations by management before investment decisions are taken.
1. LAZY MOWER PROJECT PROFORMA STATEMENT
The Lazy mower Pro forma Statement shows the expected cash flows of the project over its 10 year economic life, According to (Ivo Welch2008), “A ‘pro forma' is a model of a hypothetical future scenario.” It is an approach based on hypothetical analysis of evaluating a project for contemplating financing or investing. This ‘pro forma' is then used for discussion and evaluation of the proposed project.
The aim of the pro forma statement prepared for the Lazy mower project is only to make an investing decision. According to Brigham (2006) the prepared pro forma statement is useful in making the investing decision in four ways:
(1) By looking at projected statements, they can assess whether the projects' projected performance is in line with the Capital Investments Committee (CIC) expectations.
(2) Pro forma statements can be used to estimate the effect of proposed operating changes, using scenario (“what if”) analyses.
(3) Managers use pro forma statements to anticipate the firm's future financing needs if necessary. (4) Projected financial statements are used to estimate future free cash flows, which determine the company's overall value
The economic life of the project is characterised with a upward and then downward pattern in sales volume with a falling price per unit
(See appendix 1.1-1.3, showing the economic life of the project, depreciation charging and the calculation in preparing the pro forma statement)
2. SCENARIO ANALYSIS OF A 15% OPTIMISTIC AND PESSIMISTIC PROJECTION OF THE SALES FORECAST OF LAZY MOWER PROJECT
The objective of a scenario analysis is to examine how an output variable (or variables)
of interest will change as we go from scenario to scenario(Adair,2006). In this project the sales is adjusted upward (optimistic) and downward (pessimistic) by 15%. We are interested in the effects of these modifications on NPV,IRR, Annual Operating cash flows and on the expected salvage value in each of the scenarios: pessimistic (15% worse),base case and optimistic (15% better).
Unit Sales Volume
Year
Pessimistic
Base
Optimistic
Unit Price($)
Variable cost/unit ($)
1
25,500
30,000
34,500
1,000.00
400.00
2
28,900
34,000
39,100
1,000.00
400.00
3
32,980
38,800
44,620
1,000.00
400.00
4
32,300
38,000
43,700
950.00
400.00
5
30,600
36,000
41,400
950.00
400.00
6
30,600
36,000
41,400
950.00
400.00
7
30,175
35,500
40,825
950.00
400.00
8
29,750
35,000
40,250
900.00
400.00
9
29,325
34,500
39,675
900.00
400.00
10
28,900
34,000
39,100
900.00
400.00
Scenario Summary
Sceranios
15% worse
Base
15% better
NPV
36,149,035.64
46,162,736.36
56,176,437.07
%change
-21.69%
-
21.69%
IRR
51.73%
60.81%
69.62%
CASH FLOW & YEAR
PESSIMISTIC
BASE FORECAST
OPTIMISTIC
CF Year 0
(20,900,000.00)
(20,900,000.00)
(20,900,000.00)
CF Year 1
9,625,520.00
11,182,520.00
12,739,520.00
CF Year 2
11,870,520.00
13,860,120.00
15,849,720.00
CF Year 3
12,976,200.00
15,244,920.00
17,513,640.00
CF Year 4
11,619,770.00
13,709,120.00
15,798,470.00
CF Year 5
10,726,590.00
12,701,040.00
14,675,490.00
CF Year 6
10,645,840.00
12,606,040.00
14,566,240.00
CF Year 7
10,511,752.50
12,448,290.00
14,384,827.50
CF Year 8
9,145,462.50
10,894,650.00
12,643,837.50
CF Year 9
8,627,175.00
10,338,300.00
12,049,425.00
CF+Salvage Value Year 10
12,427,425.00
14,343,300.00
16,259,175.00
(See appendix 2.1 and 2.2, showing pro forma statement for both scenarios)
3. SENSITIVITY ANALYSIS
Dan and Ron should prepare report showing the effects of varying the key inputs in the project from the base level and the sensitivity of the net present value (NPV) to these variations. This analysis should be done by varying the identified key inputs one at a time, not because they are unlikely to vary together, but because we are interested in the relative importance of each of the inputs in the project (Adair, 2006)
Variables that need to be analysed in this project include: unit price, sales volume, variable cost per unit and fixed cost (it is not necessarily fixed across time).The choice of this variable is because they are important in the sense that they are also determined by the company's strategy and also influenced by competitive products (substitutes), inflation, cost of production, periods of boom and recession in the economy
The table and graph below show that of all the variables analysed NPV is most sensitive to price per unit and least sensitive to annual fixed cost.
resulting NPV
change from base level
price
unit sales
variable cost
fixed cost
-30%
11,681,253.84
26,135,334.93
60,616,817.45
47,711,922.70
-15%
28,921,995.10
36,149,035.64
53,389,776.90
46,937,329.53
0%
46,162,736.36
46,162,736.36
46,162,736.36
46,162,736.36
15%
63,403,477.61
56,176,437.07
38,935,695.81
45,388,143.18
30%
80,644,218.87
66,190,137.78
31,708,655.27
44,613,550.01
resulting NPV
change from base level
price
unit sales
variable cost
fixed cost
-30%
-75%
-43%
31%
3%
-15%
-37%
-22%
16%
2%
0%
0%
0%
0%
0%
15%
37%
22%
-16%
-2%
30%
75%
43%
-31%
-3%
(See appendix 3.1 showing variations in key inputs)
4. TREATMENT OF ANNUAL INTEREST $400,000.00
The annual interest of $400,000.00 should be ignored as the aim of the feasibility study (capital budget analysis) is to show whether the project should be invested in (investment decision) not to show the cost of financing the project (financing decision) (Adair, 2006). Moreover inclusion of the annual interest expense would give a wrong analysis as the interest rates are not fixed and they also vary with the associated project risk.
According to Brigham (2006), Interest Expenses Are Not Included in Project Cash Flows because we discount a project's cash flows by its cost of capital, and that the cost of capital is a weighted average (WACC) of the costs of debt, preferred stock, and common equity, adjusted for the project's risk. Moreover, the WACC is the rate of return necessary to satisfy all of the firm's investors—debt holders and stockholders. In other words, the project generates cash flows that are available for all investors, and we find the value of the project by discounting those cash flows at the average rate required by all investors. Therefore, we do not subtract interest when estimating a project's cash flows.
5. ACCOUNTING, CASH AND FINANCIAL BREAK EVEN POINTS
DEPRECIATION USING THE STRAIGHT LINE METHOD OVER 10YEARS
COST OF EQUIPMENT/10
$20,000,000.00/10=$2,000,000.00
TOTAL FIXED COST=ANNUAL FIXED COST+ANNUAL LEASE=$1,500,000.00+$120,000.00
ACCOUNTING BREAK EVEN POINT
(FIXED COST +DEPRECIATION)/(PRICE-VARIABLE COST)
($1,500,000.00+$120,000.00+$2,000,000.00)/($1,000.00-$400.00)
6033.33
The Accounting Break-Even ponit is when Approx 6034 units of Lazy mowers have been sold
CASH BREAK EVEN POINT
FIXED COST/(PRICE-VARIABLE COST)
($1,500,000.00+$120,000.00)/($1000-$400)
2700
The Cash Break-Even ponit is when 2700 units of Lazy mowers have been sold
FINANCIAL BREAK EVEN POINT
(FIXED COST+OPERATING CASH FLOW:CF)/(PRICE-VARIABLE COST)
Inputs required to calculate the financial breakeven point:
1. Initial Investment
$20,900,000.00
2.Discounted Salvage value
4,170,000.00/(1+14%)^10
$1,124,831.69
3.Discount Rate( r)
14%
4.CF= Annual operating cash flow which the discount rate will be applied on and the NPV will be zero
5.Number of periods=10years
6.PV of CF
this is calculated by finding the difference between the initial investment and the discounted salvage value
this difference is now the PV of all CF
(19,775,168.31)
so CF can be calculated using the PMT function as we now have all the variables required
CF
$3,791,167.54
Therefore the financial break even point is
($1,500,000.00+$120,000.00+$3,791,167.54)/($1,000.00-$400.00)
9018.612567
The Financial Break-Even ponit is when Approx 9019 units of Lazy mowers have been sold
6. TREATMENT OF $500,000.00 IN DEVELOPING THE PROTOTYPE OF THE LAZY MOWER
This should be treated as a sunk cost, this is because the cost of development has already being incurred, thus subsequent decisions of whether to accept or reject the Lazy Mower project cannot change this cost.(Emery et al, 2007)
7. INTERNAL RATE OF RETURN (IRR) LAZY MOWER PROJECT
The IRR which is the expected return of the project is 60.81%, this is the discount rate at which the total present value of all the project's cash flows sum to zero (Emery et al, 2007)
We recommend that the project be accepted because its IRR of 60.81% exceeds the cost of capital 14% (required return).We further support our recommendation as the IRR of the project is still higher than the cost of capital in our optimistic scenario IRR(69.62%) and even in our pessimistic scenario of 15% drop in sales where the revised IRR of 51.73% is still graeter than cost of capital (r) of 14%
(See Appendix 7.1 and 7.2 for IRR calculations)
8. SENSITIVITY OF NPV TO PROJECTS COST OF CAPITAL
The table and chart below show that NPV of the project varying the cost of capital from 0%-80%. It can be observed that the sensitivity of the NPV decreases as the cost of capital rises: the curve is steep at first and then starts to flatten out as it gets towards an NPV of 0
cost of capital
NPV ($)
0%
125,580,345.00
10%
69,722,618.68
14%
46,162,736.00
20%
41,169,341.19
30%
24,909,701.93
40%
14,811,129.69
50%
8,089,257.59
60%
3,361,204.87
70%
(114,391.99)
80%
(2,761,710.90)
9. OPERATING LEVERAGE
The operating leverage indicates the relationship between sales and operating income. For this project the operating leverage at all levels of sales is between 1.07 and 1.1,approx 1.1.This means for every 1% increase in sales there is a 1.1%increase in operating income
Operating leverage = Contribution = Sales-VC
Operating Income Sales-(VC+FC)
FC=fixed cost
VC=variable cost
Contribution=sales-VC
Operating Income=Contribution-FC
Year
Contribution
Operating Income
Operating Leverage
1
18,000,000.00
16,380,000.00
1.10
2
20,400,000.00
18,780,000.00
1.09
3
23,280,000.00
21,660,000.00
1.07
4
20,900,000.00
19,280,000.00
1.08
5
19,800,000.00
18,180,000.00
1.09
6
19,800,000.00
18,180,000.00
1.09
7
19,525,000.00
17,905,000.00
1.09
8
17,500,000.00
15,880,000.00
1.10
9
17,250,000.00
15,630,000.00
1.10
10
17,000,000.00
15,380,000.00
1.11
The operating leverage indicates the relationship between sales and operating income. For this project the operating at all levels of sales is between 1.07 and 1.11,approx 1.11. This means for every 1% increase in sales there is a 1.11%increase in operating income
10. CONTIGENCY PLANNING
Dan and Ron should include the following contingency planning to make the report comprehensive (Contingency planning being ‘back-up plans' in case original plans go wrong ):
According to Ross et al (2003), there are two options that can be considered in contingency planning during project valuation, they are:
1. The Option to Expand
Expansion option considers net present value of a project in relation to the cost of investment. Expansion of a project depends on the level of demand and largely on the Net Present Value. If a firm decides to invest in a project that has a present value (PV) of cash flows that is higher than the cost of investing in that project, the firm should continue in the expansion of the project since every firm is profit-maxi miser. So, Dan and Ron should consider expansion option for the ‘Lazy Mower' before embarking on the project .This will ensuring good consideration of how to benefit from economies of scales if the project materializes as it is being forecast.
On the other hand, if the project turns out having costs higher than its PV of cash flows, will the firm still expand it, perhaps for other certain considerations more valuable to the firm's corporate objectives in the interim? For instance, the firms might believe that the project's expansion expansion would lead to increased patronage of other products or claiming larger market shares. Though, in case of the Lazy Mower project, based on the forecast analysis portrays bright future because it has a Net Present Value of $46,162,736 higher than the initial cost of investment of $20,900,000, Dan and Ron need to consider the following in their feasibility study in relation to expansion option:
I. When expansion takes place, should there be increased production which will lead to increased expenditures, will the firm be able to meet them or curtail them?
II. What factors will impart on the price of the product? Should expansion lead to increased cost of production caused by increase in expenditure, will the price of the product go up and if it does, will it lead to reduction in demand?
III. The feasibility report should also consider if costs will reduce as expansion is embarked upon in line with economies of scale principle (reduction in costs due to expansion of a project).
IV. Effect of competition should also considered .i.e. the introduction of other similar products by other firms.
2. Option to Abandon/Suspend
The feasibility report should also think through an option to discontinue the project if need be since it is better to discontinue or abandon a project than keep a money-losing product in the market with the hopes that the economic condition will improve. Also, at what stage/ condition of production should this option be adopted? The option to suspend or contract operations should be properly looked into. If there is excess inventory can operations be temporarily suspended or permanently scaled back and costs minimized?
Bibliography
* Adair, T.A, Jr.(2006), Corporate Finance Demystified, McGraw- Hill
* Arnold, G (2008), Corporate Financial Management, 4th Edition, Prentice Hall
* Brealey, R.A, Myers, S.C, and Marcus, A.J (2001), Fundamentals of Corporate Finance, McGraw-Hill
* Ehrhardt, M.C, Brigham, E.F (2006), Corporate Finance: A Focused Approach, 2nd Edition, South-Western, Cengage Learning
* Emery, D.R, Finnerty, J.D and Stowe, J.D (2007), Corporate Financial Management, International 3rd Edition, Pearson
* Pike, R, Neale, B (2009), Corporate Finance and Investment: Decisions & Strategies, 6th Edition, Prentice Hall
* Ross,S.A, Westerfield, R.W, Jaffe, J (2003), Corporate Finance(Volume 1),6th Edition, McGraw-Hill
* Welch, I (2008), A First Course in Corporate Finance, Addison-Wesley-Pearson-Prentice-Hall (P&C).
Bibliography
1) Adair, T.A, Jr.(2006), Corporate Finance Demystified, McGraw- Hill
2) Arnold, G (2008), Corporate Financial Management, 4th Edition, Prentice Hall
3) Brealey, R.A, Myers, S.C, and Marcus, A.J (2001), Fundamentals of Corporate Finance, McGraw-Hill
4) Ehrhardt, M.C, Brigham, E.F (2006), Corporate Finance: A Focused Approach, 2nd Edition, South-Western, Cengage Learning
5) Emery, D.R, Finnerty, J.D and Stowe, J.D (2007), Corporate Financial Management, International 3rd Edition, Pearson
6) Pike, R, Neale, B (2009), Corporate Finance and Investment: Decisions & Strategies, 6th Edition, Prentice Hall
7) Ross,S.A, Westerfield, R.W, Jaffe, J (2003), Corporate Finance(Volume 1),6th Edition, McGraw-Hill
8) Welch, I (2008), A First Course in Corporate Finance, Addison-Wesley-Pearson-Prentice-Hall (P&C).
