The Relationship between Cash Flow and Capital Budgeting

Capital budgeting is an important area in corporate finance. Since long term projects or investments require massive initial outflows, a firm has to determine whether they are worthwhile and not drain the firm's resources. This is because it is often difficult to reverse a capital investment once it is in progress. There are many investment appraisal techniques that are commonly used by a company, each having its own strengths and weaknesses. The report discusses the capital budgeting decision made my one company, Alpha Electronics Ltd in deciding whether to launch a new Personal Digital Assistant (PDA).

ANNUAL CASH FLOWS

The first step in capital budgeting is to estimate the annual cash flows during the lifetime of the project. The cash flows for each year of the PDA project for Alpha Electronics Ltd are as follows:

Sales revenue 17,500,000 20,000,000 25,000,000 21,250,000 18,750,000 Sale of equipment 3,000,000 Total inflow 17,500,000 20,000,000 25,000,000 21,250,000 21,750,000 Variable production cost 6,020,000 6,880,000 8,600,000 7,310,000 6,450,000 Fixed production cost 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 Depreciation 2,250,000 2,250,000 2,250,000 2,250,000 2,250,000 Total expenses 11,270,000 12,130,000 13,850,000 12,560,000 11,700,000 Profit before tax 6,230,000 7,870,000 11,150,000 8,690,000 10,050,000 Less: Tax 2,180,500 2,754,500 3,902,500 3,041,500 3,517,500 Profit after tax 4,049,500 5,115,500 7,247,500 5,648,500 6,532,500 Add: Depreciation 2,250,000 2,250,000 2,250,000 2,250,000 2,250,000 6,299,500 7,365,500 9,497,500 7,898,500 8,782,500 Less: Net working capital 3,500,000 4,000,000 5,000,000 4,250,000 3,750,000 Net cash flow 2,799,500 3,365,500 4,497,500 3,648,500 5,032,500 Based on these figures, it appears that the project generates positive cash flows throughout the five years. However, cash flows in themselves do not tell the entire story. What is more important is determining whether the cash flows are in excess of the capital invested in the project to warrant its undertaking.

INVESTMENT APPRAISAL TECHNIQUES

 Payback Period

The payback period is the time it takes a company to recoup the amount invested in a project. This is the simplest investment appraisal technique both in terms of calculation and conceptually since it is easy to understand the concept of the length of time needed to pay off an investment (McLaney, 2001). For these reasons, it is highly popular. However, there are many drawbacks of this approach. The first is that it does not include the time value of money which makes it less accurate. Secondly, the long term profitability of a project is not the same as the payback time (Ross et al, 2005). For example, Project A may have a longer payback period than Project B, but it may also yield more profits in the long run. Focusing on the payback period will cause a company to choose an investment that has a shorter payback period over a project that brings greater long term benefits to the company. For this PDA project of Alpha Electronics Ltd, the payback period is 4.33 years. This is relatively long considering that the project has a life of 5 years and means that the company will only be able its cash outlay in the final year of the project.

Profitability Index

The profitability index is calculated by dividing the total of the project's cash flows with the cost of investment. If a project has a profitability index that is greater than 1, it is accepted. If the profitability index is less than 1, the project is rejected (Bodie and Merton, 2002). The profitability index is relatively straightforward to calculate. Yet, the problem associated with it is when two mutually exclusive projects are considered. A project that has the highest profitability index may not be the most profitable. Similarly, if funds are limited, the profitability index loses its usefulness. The same occurs in terms of indivisibilities (Brealey et al, 2007). At a discount rate of 12%, the total present value of inflows is $13, 558, 005. The cost of the investment is $15, 950, 000. This means the project has a profitability index of 0.85. Using the general rule of thumb, the project should therefore be rejected since it has a profitability index that is less than 1.

Internal Rate of Return

The internal rate of return (IRR) is the discount rate that will result in a net present value of zero. The value of an investment is determined by comparing its IRR with that of the company's hurdle, or normal discount rate. If the IRR of the project is higher than its hurdle rate, then the project is accepted. If the IRR is lower than its hurdle rate, then the project is rejected (Ross et al, 2005). The strength of the IRR is that it provides users with a discount rate that the project must achieve. Yet, the disadvantages of IRR are numerous. Firstly, it is difficult and time consuming to compute manually, though the problem does not arise when a financial calculator or financial software is used. Secondly, the IRR does not tell how much the project will earn the company in the long run, which is an important consideration in capital budgeting. Thirdly, there exists the problem of multiple IRRs or no IRR for particular projects, particularly those with irregular cash flows (Haugen, 2001). The internal rate of return is calculated using the interpolation method. Two different discount rates are used to calculate different NPVs, one having a positive value and the other negative. Based on the calculations (Appendix 1), the IRR of the project is 6.24%. This is approximately half of the hurdle rate and is unacceptable. Therefore, the project must be rejected on the basis of its low IRR.

Net Present Value

The net present value (NPV) of a project is the present value of all its future cash inflows less its initial outflow. This will enable the firm to decide how much it can earn from a project. A project is accepted if it generates a positive NPV while it is rejected if it generates a negative NPV (Watson and Head, 2001). The NPV is the best among all the investment appraisal methods. It is conceptually clear and meaningful to an organization. It does not have any of the serious weaknesses associated with other methods (McLaney, 2001). The NPV of this project is calculated as follows:

QUALITATIVE FACTORS IN INVESTMENT DECISION MAKING

While quantitative factors are given due consideration in capital budgeting, qualitative factors should not be ignored. This is because a project that may not satisfy quantitative factors may have to be undertaken due to qualitative factors and vice versa. Let us now consider some of the main qualitative factors that are crucial to effective investment decision making. The first factor is the company's strategic objectives (Copeland and Weston, 1992). Often, an investment decision may not be profitable or yield a positive cash flow, but it is necessary to enable the firm to have a competitive advantage. For example, an electronics firm may decide to buy over a manufacturer of components to ensure a supply of raw materials, even if it means that the manufacturer is running at a loss. Another qualitative factor is company prestige and image (Haugen, 2001). Sometimes, an investment may be unprofitable, but it may raise the profile of the company and the related prestige is something that may warrant the investment. For example, a company may decide to embark on corporate social responsibility activities that may represent an outflow, but it demonstrates a good corporate profile to the public so the company may regard the activity as necessary. The third factor is government regulations (Brealey et al, 2007). If the government mandates certain items to be included, then the company is forced to include them. For instance, a nuclear power plant is required to have a system and storage facility for nuclear waste. Even though such facilities constitute a negative investment, the power plant needs to include it if it wants to get the necessary government approval. The government may also require a firm to put in place employee safety measures that may be difficult to quantify, but are necessary for operations.

CONCLUSION

Based on the various investment appraisal techniques, it can be concluded that producing the new PDA is an unprofitable project. This is because the project has a low profitability index, a long payback period, negative NPV and IRR. In addition, there are no

 RECOMMENDATIONS

Even though the investment appraisal techniques indicate that the company should not embark on this project, it is felt that the analysis is incomplete. This is because all the projected cash flows are for a given level of activity when it would be better to show them under different scenarios. After all, the actual outcome may be better, worse or the same as the expected outcome. Therefore, the company should do scenario analysis in which the NPVs and IRRs of the project are calculated under different scenarios. This will give the company a better indication on whether the project is worth undertaking. More detailed sensitivity analysis should also be done to determine the changes in variables that will influence the NPV and IRR the most. The company could even use Monte Carlo simulation to model uncertainty in a real-world environment.

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