The Importance of Capital Budgeting Techniques

Financing and investment reporting aid the management team in making sound financial decisions to drive the growth and expansion of the company (Kapellas & Siougle, 2017). Most organisations are faced daily with difficult decisions on whether to invest now, postpone or refrain from investing in a project that has the potential of generating revenue for the company. As a result, the critical concepts of capital budgeting techniques and the time value of money are crucial in providing accurate financial information which results to sound decision making. The financial report focuses on recommendations to McCormick and Company, a manufacturing company interested in purchasing a new factory as they expand their product line. The analysis provides the guidance on whether they should buy the factory or not and which product line they should invest in. The information provided to the management team is crucial in determining whether the potential investment for the organisation will generate the required return sufficient for future expansion.

Recommendation on whether the factory should be purchased

Most of the organisations seek to achieve the going concern principle, by ensuring that they grow and expand. Companies which continuously expand their production are assured of increased revenue resulting in to stability. The management team need accurate and reliable information for them to make informed decisions. Capital budgeting techniques provide critical insights to the management team to make sound investment decisions. The net present value calculation is a technique which determines the net present return to the company by deducting the present value of cash inflows and the present value of cash outflows over a period of time to determine the profitability (Truong, Partington & Peat, 2008). The technique of the net present value utilizes the concept of the time value of money. Investors strongly believe that money available at the present time holds greater economic value due to its present earning capacity compared to the identical sum in the future (Batra & Verma, 2014). As a result, most of the investors prefer to receive the return of the investment today compared to in the future due to the potential growth over the years to come.

Any investment decision should be backed by a rational technique. The desired position for any current investment with future cash flows is to have the projected earnings to be generated by the project exceeding the anticipated costs discounted at the present value. Hence, an investment with a positive NPV is considered to be profitable while the negative NPV indicates a loss. McCormick and Company are interested in the potential acquisition of an additional factory and hence they are interested to determine if the decision will be profitable over the five year period. The current net present value of the factory is $118,080. The growth in the net present value based on the cash flows to be generated by the factory are as shown below;

McCormick and Company should purchase the factory as the company will recover the investment value of the company within the first three years despite the declining net present value of the cash flows from year one to year three. Hence the, risk free cash flows of year three and year four can be invested with a risk free return of 7%. Moreover, the analysis over the five year period reveals that the present value of the cash inflows exceed the net present value of the initial cost of acquisition of the factory hence the company should purchase the factory.

Recommendation on which project the company should invest in

Companies which make sound investment decisions based on the extra cash flow that they earn generate more revenue. The investment in the additional projects should not only consider the potential cash flows to be generated but also the overall net present value to the company. The management of McCormick and Company is considering investing in either project A or project B. Project B generates more future cash flows compared to project A which is closely related to the current products being produced by the company. Hence, the overall decision beneficial to the company is to invest in a project that will generate a positive net present value to the company despite the cash flows that are generated by the project.

The cash flows for the different projects are as shown below;

Cash flows of the Projects

Year 1

Year 2

Year 3

Year 4

Year 5

Project A

$5,000,000

$10,000,000

$10,000,000

$15,000,000

$15,000,000

Project B

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$20,000,000

The net present value of both projects, over a period of five years is as shown below;

Project A

Year

Cash Flow

7% discount rate

Present Value

0

-40,000,000

1

-40,000,000

1

5,000,000

0.93

$4,672,897.20

2

10,000,000

0.86

$8,734,387.28

3

10,000,000

0.79

$8,162,978.77

4

15,000,000

0.72

$11,443,428.18

5

15,000,000

0.65

$10,694,792.69

Net Present Value

$3,708,484.12

Project B

Year

Cash Flow

20% discount rate

Present Value

0

-40,000,000

1

-40,000,000

1

5,000,000

0.8

$4,166,666.67

2

10,000,000

0.6

$6,944,444.44

3

15,000,000

0.4

$8,680,555.56

4

20,000,000

0.2

$9,645,061.73

5

20,000,000

0

$8,037,551.44

Net Present Value

($2,525,720.16)

The company should only invest in project A since it yields an overall positive net present value of $3,708,484.12 compared to project B which yields an overall Net present value of ($2,525,720.16). Investors usually seek to generate the maximum return for every investment that they put a stake in. As a result, by investing in project A, the management team of McCormick and Company is assured of a net positive return of over three million dollars after the full recovery of the initial cost of the investment of 40 million dollars. On the other hand, the company risks generating a loss of 2 million dollars if they invest in project B despite the fact that it has high overall cash flows.

Conclusion

In conclusion, the company should invest in the factory. The findings reveal that the company will recover its investments by the third year. As a result, the cash flows for the third and the fourth year can be used for other investments at a risk free rate of 7%. The future cash flow earnings by the company were discounted to determine the net present value at the cost of capital of 20%. Hence, the fact that the net present values of the cash flows exceed the net present value of the investment makes the purchase of the factory a viable investment. Moreover, between project A and project B, the company should invest in project A since it has a positive net present value of $3,708,484.12 over the five year period compared to project B which has a negative net present value of ($2,525,720.16).

References

Batra, R., & Verma, S. (2014). An Empirical Insight into Different Stages of Capital Budgeting. Global Business Review, 15(2), 2-7. doi: https://doi.org/10.1177%2F0972150914523588

Kapellas, K., & Siougle, G. (2017). Financial Reporting Practices and Investment Decisions: A Review of the Literature. Industrial Engineering & Management, 6(4), 235. doi: https://doi.org/10.4172/2169-0316.1000235

Truong, G., Partington, G., & Peat, M. (2008). Cost-of-Capital Estimation and Capital-Budgeting Practice in Australia. Australian Journal Of Management, 33(1), 3-4. doi: https://doi.org/10.1177%2F031289620803300106