Introduction
Capital budgeting decisions are essential to managers because it helps them make strategic decisions. Specifically, it helps managers to make decisions on whether to commit resources in order to maximize the wealth of shareholders. There are various techniques used to establish whether a project should be accepted or rejected. For instance, the net present value model is commonly used to determine the profitability of major projects in many companies because it take into account the time value of money (Dayanada 38). This model helps managers to make decisions on whether to invest or not because it ranks projects in absolute terms.
The net present value model was applied to establish whether ABC Golf Equipment Corporation should invest in the new project. The outcome of this capital budgeting calculations will help managers to establish whether it is worth committing resources on the project or not. According to the net present value model, the project has a negative present value. Therefore, it should be rejected. A negative NPV is an indicator that the project will not generate revenues.
Changing the cash flow
If the company plans to finance the project using debt capital, they have to change the cash flow projection. It is imperative for the company to change the projected cash flow since it shows a negative present value. This is because banks consider the expected cash flow from an investment before granting loans. It is in the best interest of the company to change the expected revenues in order for the project to reflect a positive cash flow. According to Bierman and Smidt, banks will always consider the cash flow cycle from purchases of inventory through to the collection of account receivable (34). The primary concern of the banks is whether the business will generate adequate daily cash flow to meet its own expenditures including those of the bank. A positive cash flow shows the lender how cash expenditure relates to revenues.
This information helps the bank to understand the demand of the product and future profitability of the business. If management intends to finance the business using borrowed money, they must change the expected sales. For instance, management project that the demand of golf will be 500 units per year. In order to ensure the business reports positive cash flow, future demand should increase to about 3000 units per year. The best strategy that can be applied by the company in order to prove their creditworthiness is preparing a cash flow that shows a positive net present value. The trick is to demonstrate that the business will be able to repay the loan. In this case, the best strategy would be to change the cash flow in order to reflect a positive cash flow. This can be achieved in two ways. First, management should reduce the projected operating expenses. If managers reduce operating expenses from 75 percent to about 30 percent, then cash flow will increase. Secondly, managers can increase the number of units sold. The project has an expected demand and selling pricing as shown in the table below.
If the company prepares a cash flow showing that the expected sales will increase from 500 to 3000, the project will report a positive net present value. Managers should consider changing the projected operational costs. The current operational cost is very high. In fact, management expects operational costs to be about 75 percent of the total revenues. This is an indicator that the business will have a negative cash flow because it does not even include depreciation. If depreciation were to be included in the operating expenses, then the percentage would rise to 80 percent. The project will reflect a positive cash flow if operational costs are reduced significantly. For instance, managers can estimate operating costs to be about 35 percent of total revenues. If operational costs are reduced, revenues will rise which will be reflected as a positive cash flow. Since lenders consider whether a project will generate adequate cash flow to repay the loan, a positive cash flow projection will look attractive to the bank.
Sunk costs in capital budgeting
If the company spent $200,000 on research and development, this cost cannot be considered in capital budgeting decisions. Usually, costs that have already been incurred are considered irrelevant in capital budgeting decisions. The costs that have already been incurred as referred to as sunk costs. These costs are not considered in capital budgeting because they have already been incurred, thus, they do not affect future decisions. When making capital budgeting decisions, only variable and fixed costs, which will be incurred in the project are considered relevant. Any other cost that was incurred before the project started to generate revenues is considered irrelevant (Peterson and Fabozzi 56). Sunk costs include research and development costs incurred before the project commenced. These costs should not be included in decision-making. When determining the net profit, accountant treats them as operating expenses. Thus, sunk costs cannot be included in capital budgeting decision. Decision makers usually ignore sunk cost and instead consider the expected future cash flow from that project. Therefore, cash outflow from the business in research and development of the golf project cannot be included in determining future cash flow.
Should the company rent the factory for $80, 000
In capital budgeting decisions, a project should only be accepted if it generates positive cash flow. Since this project has a negative net present value, the company should reject the project and rent the factor. The factory is used to manufacture golfs, thus, the value of the factory is the present value of the investment. The expected benefit from the factory is the revenues generated from golf. Since the demand for golf is very low, managers should rent the factory. If they decide to continue with the project, the company will incur losses amounting to $1,477.89. Therefore, instead of generating negative cash flow, renting the factory would allow the company to receive $80, 000 in revenues. The present value of the project is shown in the tables below.
Incremental depreciation: 2050, 000 -40,000/10 = 201, 000
Incremental initial outlay.
Calculating the present value of future cash flow from the project.
From the analysis above, the project has a negative cash flow which is an indicator the company will incur losses if management decides to invest in the project. The value of the factory can be attributed to the value of the investment. Therefore, the income generates from the project is the value of the factory. If the factory is not being used to generate additional income, managers should consider renting it for $80, 000. If management rent the factory, the company will generate positive cash flow instead of losses. However, a critical analysis of the project shows that managers over exaggerated operating expense. The operational expense is estimated at 75 percent of the total revenue generated from the project. This figure represents a huge expense. In fact, it shows that 80 percent of revenue is made up of expense.
Recommendation
The current demand in the market cannot meet the initial cost of the project. Therefore, increasing sales unit means that revenues will increase. This will turn the negative net present value into positive cash flow that is considered attractive by lenders. However, if the business has other assets, they can be used as collateral instead of presenting cash flows from the project. Moreover, if the company is generating profits in other segments, management can present those cash flows to prove the creditworthiness of the business. The main challenge in this project is the initial outlay. The project has a very high initial outlay that must be recovered in the next five to six years in order for the project to generate positive revenues. Since the project has a negative net present value, it should be discarded because it will not be profitable in future. Therefore, managers should rent the factory for $80, 000. If the factory is not available for rent, managers should invest in a new project that will generate positive cash flows.
Short essay
Many factors should be considered in capital budgeting decisions. Some of these factors include the impact of the project on organizational culture and future cash flow. For instance, if a capital budgeting decision affects employee motivation, it should either be rejected or implemented after consultation with employees. A capital budgeting decision might have positive cash flow; however, if managers decide to implement it, it might come at a cost. Thus, it is imperative to do a cost-benefit analysis before implementing capital budgeting decisions.
If the company decides to continue with the venture, it will lose 20 percent of its market share. These factors have to be considered because the company will lose a significant part of its market share. First, if the company decides to invest in the project, there are consequences. These consequences should only be accepted if the golf project would generate adequate revenues that will offset more than 20 percent of its revenue. Since the project cannot even generate positive revenues, managers should reject the project. If they decide to continue with the project, the company will incur double losses. Secondly, the project has a negative cash flow which will only drive the company into further losses. Therefore, before making capital budgeting decisions, it is imperative for managers to consider other external factors that might affect the business.
Other factors that should be considered in capital budgeting
Even if a project has a positive cash flow, managers should examine other internal and external factors that might affect the business. Some of these factors are qualitative while others are quantitative. Qualitative factors can be measured instinctively while quantitative factors can be measured by objectively. Capital budgeting decisions are highly driven by quantitative factors such as the price of an asset or expected returns. These quantitative factors must be considered before making capital budgeting decision (Heisinger 376). For instance, decision makers must consider the price of an asset because it has a direct impact on future cash flow. The price of the machine should represent it market fair value. Managers should avoid purchasing assets that are overpriced because it will have a negative impact on the future cash flow of the project. Understanding these qualitative decisions will help managers to make sound investment decisions.
Managers should consider the impact of capital decisions on the company’s culture. Therefore, it becomes paramount to consider the impact of capital budgeting decisions on workers and organizational culture. For instance, if a capital budgeting decision leads to an additional office complex in another city, it may change how information flows in the organization. Moreover, it will affect team relationship which will have a direct impact job performance (Brigham and Ehrhardt 425). If managers in a small company decide to automate their systems, they have to consider the impact it will have on team dynamics and factory floor. Before undertaking capital budgeting decisions, managers need to understand the impact of committing huge resources to the organizational culture and workplace relationship (Johnson 45). If a capital decision will have a negative impact on the things workers value most, it might be essential for managers to consider consulting workers in order to avoid conflicts.
Conclusion
In summary, managers must consider both qualitative and quantitative factors that affect capital budgeting decisions. Since the project generates negative cash flows, managers should not invest in the project. They must consider the impact of the project on market share and organizational culture.
Works Cited
Bierman, Harold, and Seymour Smidt. The capital budgeting decision : economic analysis of investment projects. New York London: Routledge, 2007. Print.
Brigham, M., and Michael C. Ehrhardt. Financial management : theory and practice. Mason, OH: Thomson South-Western, 2008. Print.
Dayanada, Don. Capital budgeting: financial appraisal of investment projects. Cambridge, UK New York, NY, USA: Cambridge University Press, 2002. Print.
Heisinger, Kurt. Essentials of managerial accounting. Mason, OH: Southern-Western Cengage Learning, 2010. Print.
Johnson, Hazel J. Making capital budgeting decisions: maximizing the value of the firm. Harlow: Financial Times/Prentice Hall, 2005. Print.
Peterson, Pamela P., and Frank J. Fabozzi. Capital budgeting: theory and practice. New York, NY: Wiley, 2002. Print.