6.2 Conventional Capital Budgeting Analysis of A Manufacturing Company (Being corrected)

 

Capital budgeting is the process of undertaking the evaluation of potential major investments or projects. Some examples of projects that require capital budgeting before approval or rejection can be the big investment in outside ventures or new plant construction (Kenton, 2021). In the case of a manufacturing company being concerned, the company is evaluating two new equipment options to be chosen as a new product suitble for the production enhancement. The company’s manager requested the finance and accounting department to give recommendations on how to choose the best option based on capital budgeting analysis.

The three main capital budgeting calculations to be performed are NPV, IRR and Payback period. In more detail explanation, in relation to the available data of the problem, they can be defined and articulated as,    

1.      NPV (Net present value) is the difference between cash outflow and cash inflow’s present values over a period of time. In my detail calculations, a present value of a time period is the multiplication between present value factor (PV = 1/(1+r)ⁿ, r = rate of return, n = periods) and total cash in or out of that period. And the net present value is sum of all available periods. Positive NPV  means that ,in present dollars, anticipated costs are less than projected earnings. In other words, Positive NPV indicates profitable investments  and Negative NPV indicates unprofitable ones (Fernando, 2021).

2.       IRR (Internal rate of return) is a used metric for financial analysis to do the estimation of potential investment’s profitability. In a discounted analysis of cash flows, it is a rate of discount making the NPV of all cash flows  (Fernando, 2021).

0 = NPV = sum_t=1^t=T (C_t ​/(1+IRR)^t  - C₀ )

​where :

C_t ​ = Net cash inflow during the period t

C₀ = Total initial investment costs

IRR=The internal rate of return

t=The number of time periods​
 

In general, higher IRR means better investment based on the definition to make total NPV quickly goes to zero (Ganti,2021). In this research, general excel formula to calculate the IRR can be written as : =IRR(Total cash at year 0: Total cash at year n, initial guess value)

3.      Payback period is the required amount of time for the investment cost recovery. In other word, it is the time for the investment to reach the Break Even Point (BEP) (Kagan , 2021 ). Our detail calculation purpose in the excel sheet uses the fact that the payback period is the time at exactly zero cumulative cash flow. In the two options, no zero cumulative cash flows are available. Therefore, we use the linear regression technique to find the linear equation to find the Payback period which is the year as the x axis at which cumulative cash flow is exactly zero at the y axis.     

 

Based on the above definition and articulation, further summary of calculation can be done by the following table,

Required rate of return for both options

0.08

For Option 1 :

Therefore, for Option1 :

Present value = total cash * PV (Present Value) factor

NPV = sum(B14:I14) = $ 56470.64163

IRR = IRR(B10:I10,0.1072) = 18% ;  (Note : 0.1072 is a guessing value )

Payback Period = 4 years 10.13114754 months

(the x value =295500/61000 =4.844262295 years,  for y value = $ 0 (Cumulative cash flows)  at the equation of y = 61000x -295500)

For Option 2 :

Therefore, for Option 2 :

Present value = total cash * PV (Present Value) factor

NPV =SUM(B29:I29) = $ - 9336.578665

IRR = =IRR(B25:I25,0.1072) = 9% ;  (Note : 0.1072 is a guessing value )

Payback Period = 5 years 9.401055537 months

(the x value =597225/103265 = 5.783421295 years,  for y value = $ 0 (Cumulative cash flows)  at the equation of y = 103265x -597225)               

Based on the calculation results, the meaning of the option 1 NPV value > 0 was previously discussed as indication of profitable investment. While the option 2 NPV value < 0 indicates unprofitable investment. IRR option 1 (18%) which is greater than IRR option 2 (9%) indicates that the IRR of option 1 is better than that of Option 2 since the higher IRR is the better investment. Moreover, the payback period of option 1 with the amount of 4 years 10.13114754 months is faster than the payback period of option 2 with the amount of 5 years 9.401055537 months.   

In conclusion, based on the above NPV, IRR, and payback period comparisons between the two options, the manufacturing company should choose the option 1 as a new equipment product suitable for the production enhancement. The analysis of preferring the option 1 is also proven right by considering the other factors that even though the price of the option 1 with no salvage value is more expansive than option 2 with salvage value of $10,000, materials, labors and maintenance costs of the option 1 is  cheaper than those of the option 2. Therefore, the option 1 is the best choice.

Note : This conventional calculation was performed using required rate of return. In the Islamic perspective, the cash flow data are based on profit and loss sharing. 

References 

Kenton, W. (2021, October 13). What is capital budgeting? Investopedia. Retrieved October 14, 2021, from https://www.investopedia.com/terms/c/capitalbudgeting.asp. 

Fernando, J. (2021, October 13). Net present value (NPV). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/n/npv.asp. 

Fernando, J. (2021, October 13). Internal Rate of Return (IRR). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/irr.asp. 

Ganti, A. (2021, October 13). Internal Rate of Return (IRR) rule. Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/internal-rate-of-return-rule.asp. 

Kagan, J. (2021, October 13). What is the payback period? Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/p/paybackperiod.asp.