Capital Budgeting For Printer Replacement: Evaluation Of Investment Plans

Evaluation of Investment Plans

Capital budgeting is the most important part of financial management as it involves evaluation of decisions regarding the capital investment in any business or project. As a large sum of capital funds of the firm is investment in these decisions for generally longer terms and it is not easily possible to reverse the decision once made, such decisions are required to be made after assessing all the potential benefits and risks involved in the possible investment plans. To evaluate each proposal of capital investment the project or business managers must use various techniques of capital budgeting such as Net present value, Payback period or Internal rate of return etc.

In the instant case of CQU Printers, the firm has to critically evaluate the replacement decision and the year in which such decision must be implemented. Also, the firm has to select the most appropriate investment option between Printer A or Printer B so as to increase its profitability with the efficient utilization of resources available with it.

1. Initial investment:

Initial investment is the deployment of capital funds in the acquisition and installation of an asset to the business or to undertake any project. It is made in the base year. In the given case, the firm is selling the old printer and the value realized on its sale will be deducted from the cost of new printer. Cost of new printer will include both the acquisition and installation cost (Correia & Cramer, 2008). The initial investment required to be made in the replacement printers are determined below.

Printer A

Printer B

1. Operating cash flows:

Operating cash flows associated with any asset or business covers both inflow as well as outflow of cash from the normal operations of the business. In this case, the profits earned by the firm with the use printers are taken as operating cash flows (Danielson & Scott, 2006). The operating cash flows of replacement printers are calculated following the incremental approach where the profits before depreciation and depreciation.

PRINTER A

PRINTER B

1. Terminal cash flows:

The cash flows from activities other than operating and that occur in the last year of project duration or useful life of the concerned asset, are the terminal cash flows of the project or business. In the given case, the useful life of all the printers is 5 years and at the end of 5^th year the new printers are expected to be sold out by the firm. Therefore, the value realized on sale of printers will be the terminal cash flows of the business. The capital gain taxation has been ignored while calculating the terminal cash flows as per the requirement of the case.

Initial Investment

Cash flow stream associated with each of the replacement printer will encompass the initial investment net of amount realized on sale of old printer, net operating cash flows after tax and depreciation and the terminal cash flows. All these cash flows are discounted at the rate given in the question to determine the present value of the cash flows.

PRINTER A

PRINTER B

Part C:

1. Payback Period:

In capital budgeting, the time period required to recoup the invested funds in the project is called as the payback period. This is the breakeven point at which the project earns as much of the returns as required to cover the initial cost of project. At this point the project is neither at loss nor at profit (Bennouna, Meredith & Marchant, 2010). Payback period of any project or asset is an important capital budgeting technique to determine the project feasibility. As a general rule projects with lower payback periods are preferable as they have the capacity of recovering the cost of project quickly than the projects with longer payback periods.

In the given case, Printer B has a payback period of 2.80 years and Printer A has a payback period of 3.63 years, hence Printer B must be selected by the firm as cash inflows of printer B are capable of recovering the cost of printers in shorter duration than printer A.

PRINTER A

PRINTER B

Net present value is a valuable tool used in capital budgeting to assess the project’s success. It is the difference between the present value of cash inflows associated with the assets and the present value of cash outflows (Dayananda, 2002). Present values of cash flows are calculated taking into account the time value of money and therefore the cash flows of the project are discounted using the discounting rate of return. The project which has positive NPV is profitable to be invested in but when all the proposed investments have positive NPV, the project with higher NPV is selected (Baker & English, 2011).

In the present case, NPVs of both the investment options i.e. Printer A and Printer B are calculated using the discounting rate of 14%. The NPV of project A is greater than Project B’s NPV and hence Printer A is preferred over Printer B as project A is more profitable in terms of returns.

PRINTER A

It is the important technique of capital budgeting as it is used to measure the profitability of the investments. At this rate the NPV of the project is zero (Truong, Partington & Peat, 2008). Higher internal rate of return of a project is desirable (Brijlal, 2008).

Operating Cash Flows

In this case the IRR of printer B is 37.93% and printer A is 24.40% and hence printer B must be selected.

Printer A

Data Table

Printer B

1. Conflicts of results:

Since both the capital budgeting techniques i.e. NPV and IRR are providing the favorable results for the investment in Printer B, there is no conflict of choice under both the techniques. Under both the techniques Printer B is ranked above Printer A. Hence it can be observed that printer B is more profitable than printer A.

1. Decision making under the different situations:

• Unlimited Funds:

Whenever firm has unlimited funds to utilize in the capital investments, the decision become making quite simple and it can be based on the returns generated by the investment proposals (Perold, 2005). If the firm has unlimited funds it can invest in purchasing both the printers as it will enhance its productivity and thereby it will contribute to generation of higher revenues from the business (Peterson & Fabozzi, 2002). As the NPVs of both the printers are positive it can be said that investment in both the printers will bring profitability for the business.

• Capital Rationing:

It is the situation in which the business is short of funds. When the funds requirement is more than the availability of funds, the situation of capital rationing arises. In such situations all the proposed capital investment plans e ranked on certain basis whether it is based on the risk or returns attached to the investment proposals (Bierman & Smidt, 2012). Then the project with least risk and maximum possible return is selected for the investment purpose. In the current situation, the company must choose to invest in Printer B as per the outcomes of application of NPV and IRR techniques.

The consistency of cash flows reduces the risk of the concerned investment plan as there is no uncertainty attached to the quantum of cash flows that the project is going to generate in the future years (Ross, Westerfield & Jaffe, 2002). However, with the lower risk, the project is also not able to offer higher returns to the managers. Whereas, in case of fluctuating returns, there is higher risk involved with the project due to the uncertainties of quantum of cash inflows to be generated in future (Correia & Cramer, 2008). However, since there always remains the probability of earning higher returns. In this case Printer B is offering uniform profits for all the years hence it is less risky and at the same time it is offering less returns. On the other hand, printer A is offering higher returns as there is higher risk involved. If the firm is not open to take risk then it must not go with printer A rather it should invest in printer B as it will provide uniformity of returns each year (Ehrhardt & Daves, 2000).

Conclusion:

On the overall basis it can concluded that capital investment decisions are significant part of project planning as they involve huge funds and are generally irreversible and hence all the proposed investment plans needs to be critically analyzed before reaching on any decision. In the present case, it is observed that investment in Printer B is more beneficial.

References

Baker, H. K., & English, P. (2011). Capital budgeting valuation: Financial analysis for today’s investment projects (Vol. 13). John Wiley & Sons.

Bennouna, K., Meredith, G. G., & Marchant, T. (2010). Improved capital budgeting decision making: evidence from Canada. Management decision, 48(2), 225-247.

Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.

Brijlal, P. (2008). The use of capital budgeting techniques in businesses: A perspective from the Western Cape.

Correia, C., & Cramer, P. (2008). An analysis of cost of capital, capital structure and capital budgeting practices: a survey of South African listed companies. Meditari accountancy research, 16(2), 31-52.

Danielson, M. G., & Scott, J. A. (2006). The capital budgeting decisions of small businesses. Journal of Applied Finance, 16(2), 45.

Dayananda, D. (2002). Capital budgeting: financial appraisal of investment projects. Cambridge University Press.

Ehrhardt, M. C., & Daves, P. R. (2000). Capital budgeting: The valuation of unusual, irregular, or extraordinary cash flows. Financial practice and education, 10, 106-114.

Perold, A. F. (2005). Capital allocation in financial firms. Journal of Applied Corporate Finance, 17(3), 110-118.

Peterson, P. P., & Fabozzi, F. J. (2002). Capital budgeting: theory and practice (Vol. 10). John Wiley & Sons.

Ross, S. A., Westerfield, R. W., & Jaffe, J. F. (2002). Corporate Finance.

Truong, G., Partington, G., & Peat, M. (2008). Cost-of-capital estimation and capital-budgeting practice in Australia. Australian journal of management, 33(1), 95-121.

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