Finc330 Business Finance | Capital Assessment Answers

Booli Electronics is an electronics manufacturer located in Carlton, Victoria, Australia.

The Company’s Managing Director is Monica Chen, who inherited the company from her father. The company originally repaired radios and other household items when it was founded more than fifty years ago. Over the years, the company has expanded, and is now a reputable manufacturer of various specialty electronics items. Richard Das, a recent MBA graduate, has been hired by the company in the finance department.

One of the major revenue producing items manufactured by Booli Electronics is a ‘smart speaker and home assistant (SSHA).’ Booli Electronics currently has one SSHA model on the market and sales have been excellent. The SSHA is a unique item in that it comes in a variety of colours and is pre-programmed to play the AC/DC back catalogue (and nothing else) on high rotation. However, as with any electronic item, technology changes rapidly, and the current SSHA has limited features in comparison with newer models. Booli Electronics has spent $1 175 000 developing a prototype for a new SSHA that has all the features of the existing one (except for the AC/DC back catalogue), but adds new features such as Wi-Fi tethering and access to a large number of music streaming services including Spotify, Amazon Music, Sirius, Tidal and Pandora. The company has spent a further $650 000 for a marketing study to determine the expected sales figures for the new SSHA.

Booli Electronics’ production manager has produced estimates of the costs associated with manufacture of the new SSHA. Variable costs are estimated at $325 per unit in Year 1, then rising with inflation, and fixed costs for the operation are expected to run at $6.5 million per year (not rising with inflation). The estimated sales volume is 92 000 in Year 1; 142 000 units in Year 2; 108 000 units in Year 3; 71 000 units in Year 4; and 62 000 units in Year 5. The unit price of the new SSHA will be $687 in Year 1, then rising with inflation. Expected inflation is 2.% over this time. The necessary manufacturing equipment can be purchased for $45.2 million and will be depreciated for tax purposes over a seven-year life (straight-line to zero). It is believed the salvage value of the manufacturing equipment in five years’ time will be $ 9.5 million.

Net working capital for the SSHAs will be 18% of the first-year sales and will have to be purchased at the end of the year. The cost of raw materials is reflected in the variable cost per unit. Booli Electronics has a 28% corporate tax rate and a 12%, after tax, required return.?
 

Required

Monica has asked Richard to prepare a short report that answers the following questions:
1. What is the non-discounted payback period of the project? 
2. What is the profitability index of the project? 
3. What is the IRR of the project? 
4. What is the NPV of the project? 
5. How sensitive is the NPV to changes in the price of the new SSHA? 
6. How sensitive is the NPV to changes in the quantity sold of the new SSHA?
7. Should Booli Electronics produce the new SSHA?

8. Suppose Booli Electronics loses sales on other modelsrk because of the introduction of the new SSHA. How would this affect your analysis?

Answer:

Introduction:

The current report would intend to evaluate the feasibility of a particular project by using the various capital budgeting techniques. Booli Electronics is the chosen organisation in accordance with the provided case study and it is identified as a manufacturer of electronic products in Carlton, Victoria, Australia. It has been further observed that the organisation generates maximum amount of revenue from a particular item, which is smart speaker and home assistant (SSHA). However, with the rapid advancements in technology, the prototype used to manufacture this item has become obsolete. Therefore, it mandates the need for the organisation to develop a new one for which it has estimated the revenues to be earned and expenses to be incurred. For critical evaluation of the project viability, this report would shed light on the various techniques of capital budgeting to undertake the investment decision in the context of Booli Electronics.

1. Non-discounted payback period of the project:

For arriving at the non-discounted payback period and other techniques of capital budgeting mentioned below, the following computations are made.

The above tables mainly depict the calculation of initial investment, net annual cash inflows and the values of the investment appraisal techniques. In case of non-discounted payback period, it is the method expressed in number of years when the cash flows generated would help in recovering the total initial investment (Almazan, Chen and Titman 2017). A project with a lower payback period is considered feasible, as the initial investment of the organisation is at risk for a shorter timeframe. In the provided case of Booli Electronics, the payback period is obtained as 2.09 years, which is lower than the economic life of the project of five years. Hence, this project could be considered feasible for the organisation.

2. Profitability index of the project:

In the words of Andor, Mohanty and Toth (2015), profitability index is a method, which aims to detect the association between the costs and benefits of the proposed project. It is computed by dividing the present value of future cash inflows by the initial outlay. A ratio of 1 is the lowest acceptable measure, as a value lower than 1 denotes the present value of the project is lower compared to its initial investment (Rossi 2015). In this case, the profitability index is obtained as 1.65, which implies the viability of the project for Booli Electronics.

3. Internal rate of return of the project:

As commented by Burns and Walker (2015), internal rate of return helps in evaluating the project attractiveness and if it is higher than the required rate of return, the project is profitable and vice-versa. For Booli Electronics, the internal rate of return is obtained as 35.07%, which is more than the required rate of return of 12%. This implies that the project is feasible for the organisation in terms of investment decisions.

4. Net present value of the project:

Net present value helps in determining how profitable a project is in terms of monetary returns opposed to the investment made. A positive and higher value is always favourable, since greater returns are expected to be earned from the investment and vice-versa (De Andrés, De Fuente and San Martín 2015). In this case, the net present value is obtained as $37,847,147.77, which is a positive and higher value; thus, denoting the feasibility of the project.

5. Sensitivity in NPV with change in price:

For analysing the sensitivity in NPV, the selling price per unit and variable cost per unit are changed. Two cases are considered, which are described as follows:

Increase in selling price and variable cost by $10 per unit:

According to the above tables, it could be found that the rise in price per unit has resulted in net present value of $37,266,327.92, which is lower than the value obtained in the actual case scenario $37,847,147.77. However, it is still providing positive and higher return, since adequate cash flows are expected to be generated (Hall and Sibanda 2016).

Decrease in selling price and variable cost by $10 per unit:

According to the above tables, it could be found that the fall in price per unit has resulted in net present value of $37,409,596.15, which is lower than the value obtained in the actual case scenario $37,847,147.77. However, it is still providing positive and higher return, since adequate cash flows are expected to be generated (Johnson and Pfeiffer 2016). It is noteworthy to mention that if the price per unit is reduced, Booli Electronics would be able to earn more profit than in the case of increased price per unit.

6. Sensitivity in NPV with change in quantity sold: 

For analysing the sensitivity in NPV, the sales volume is changed. Two cases are considered, which are described as follows:

Increase in quantity sold by 10,000 units:

If Booli Electronics decides to sell additional 10,000 units per year, it could be observed that the net present value of the project would be $46,406,685.16, which is significantly higher than the value obtained in the actual case scenario $37,847,147.77. Thus, profit level is expected to increase further; however, the market demand is to be taken into consideration before implementing the change (Johnson, Pfeiffer and Schneider 2017).

Decrease in quantity sold by 10,000 units:

If Booli Electronics decides to minimise 10,000 units per year, it could be observed that the net present value of the project would be $28,253,666.27, which is significantly lower than the value obtained in the actual case scenario $37,847,147.77. Thus, profit level is expected to decline significantly. Hence, it could be stated that the net present value is more sensitive to the change in sales volume rather than the change in price per unit (Johnson, Pfeiffer and Schneider 2017).

7. Feasibility of the new SSHA:

Based on the above evaluation, it could be stated that all the investment appraisal techniques used to evaluate the viability of the project for Booli Electronics have provided positive signal. Even the changes in the price per unit and sales volume would fetch positive and profitable returns for the organisation. Therefore, it is advised to the management of Booli Electronics to proceed ahead with the project, since it would maximise its overall return on investment.

8. Discussion of whether sales would be lost in other models due to the introduction of the new SSHA:

It could be identified that the major revenue producing item for Booli Electronics is the SSHA and hence, improvement in this model through additional investment might minimise the sales revenue of the organisation from other models. In such situation, two options need to be taken into consideration (Robinson and Burnett 2016). Firstly, it needs to be checked whether the profit generated from the new SSHA would be able to offset the fall in revenue from other models. Secondly, if the overall sales revenue of the organisation is decreased, it needs to consider raising the sales volume, as higher sales would raise its revenue generating capacity (Rossi 2014). In that case, the analysis needs to be made by considering the other models that Booli Electronics sells in the market.

Conclusion:

The above discussion makes it evident that the new SSHA would be highly profitable for Booli Electronics, as the return on investment would be maximised. This is validated by using the several investment appraisal techniques like payback period, internal rate of return, profitability index and net present value. Even the sensitivity analysis conducted implies that the organisation could make profits from the implementation of this new model. However, it needs to take into consideration the market demand and other models, as any change in these two aspects might have significant impact on the business profitability of Booli Electronics.

References:

Almazan, A., Chen, Z. and Titman, S., 2017. Firm Investment and Stakeholder Choices: A Top?Down Theory of Capital Budgeting. The Journal of Finance, 72(5), pp.2179-2228.

Andor, G., Mohanty, S.K. and Toth, T., 2015. Capital budgeting practices: A survey of Central and Eastern European firms. Emerging Markets Review, 23, pp.148-172.

Burns, R. and Walker, J., 2015. Capital budgeting surveys: the future is now.

De Andrés, P., De Fuente, G. and San Martín, P., 2015. Capital budgeting practices in Spain. BRQ Business Research Quarterly, 18(1), pp.37-56.

Hall, J.H. and Sibanda, T., 2016. Capital Budgeting Practices: An Empirical Study of Listed Small en Medium Enterprises. Corporate Ownership & Control, p.200.

Johnson, N.B. and Pfeiffer, T., 2016. Capital budgeting and divisional performance measurement. Foundations and Trends® in Accounting, 10(1), pp.1-100.

Johnson, N.B., Pfeiffer, T. and Schneider, G.T., 2017. Two-Stage Capital Budgeting, Capital Charge Rates, and Resource Constraints.

Robinson, C.J. and Burnett, J.R., 2016. Financial Management Practices: An Exploratory Study of Capital Budgeting Techniques in the Caribbean Region.

Rossi, M., 2014. Capital budgeting in Europe: confronting theory with practice. International Journal of Managerial and Financial Accounting, 6(4), pp.341-356.

Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.