The corporation is making a capital budgeting decision that involves investing in the firm's long-term assets. Businesses have funds, and because they are not unlimited, they must plan how to invest in a way that will generate revenue several years in the future. It is a critical decision, and because it will have a significant long-term influence, thorough planning is required. I made some assumptions, including the following: the bicycle investment is a stand-alone initiative, meaning it has no bearing on any other projects. I have ignored the effect of taxes on capital gains and also, assumed that investment is made under conditions of certainty, and the Net Present Value (NPV) technique is used for evaluation.
In making the investment decision, three fundamental inputs must be availed: the cash flows, the discounting factor, and the project life. The project life is five years, and it is crucial because if changed, it will change the entire perspective of the project. The discounting factor ais “the firm’s opportunity cost of capital, and it is equal to the required rate of return investors expect on an investment of equivalent risk” (Gitman, Juchau, & Flanagan, 2015). It is applied to the company’s future cash flows and get their present values.
Cash-Flows
Initial Outlay
This represents the amount required to start a project, and it is usually denoted as the cash-flow at year 0. The initial outlay consists of the cost of the equipment, any investment in working capital, and installation costs if applicable. For our case, the initial outlay has two components: purchase of the machine at $1.5 million and investment in working capital worth $150,000. Working capital refers to the capital used in the daily running of a business and examples include investment in inventory, an increase in accounts receivable, and investment in the payables. It is important to note that at the end of the project, the investment will be recovered since there will be no more inventories, all receivables will be collected, and payables paid. The IO for the bicycle project, therefore, is $1.65 million. Also, the equipment is depreciated using the straight line method, but in this case, it has a resale value of $50,000.
After-tax cash-flows
The after-tax cash-flows represent the cash generated from the company’s operations of selling bicycles after accounting for taxes (Pinto, Henry, Robinson, & Stowe, 2015). In calculating the cash-flows, we need to calculate the expected net income but most importantly, understand that there are non-cash items such as depreciation that must be added back. The first step is to get the net income using the formula sales-expenses. The company expects to sell 4000 bicycle units at $400 each year, and therefore, its annual sales are $1,600,000. The expenses consist of fixed, variable expenses, and overheads. Variable expense per unit are $75 and the total annual variable expense for all the bicycles is $300,000. The fixed expenses (do not change) are $700,000. The sales minus expenses give the operating revenue as $600,000. The overhead, in this case, is depreciation of the machine and the formula will be (cost-salvage value/5). The cost is $1.5 million while the salvage value represents the resell value at the end of the project and the annual depreciation expense is $290,000.
The operating revenue less depreciation gives a taxable income of $310,000 and by applying a tax rate of 30%, the net income per year is $217,000. However, as I pointed out earlier, depreciation is a non-cash expense and to get the after-tax cash-flows, it is added back to the net income figure. Therefore, the annual cash-flow from year 1 to year 5 is $507,000. However, we must factor in the terminal cash-flows, that is, “the cash flows that occur at the end of the project” representing the proceeds from disposal of the equipment and recouping of the working capital. In this case, the terminal cash-flows will be the sum of the salvage value of the equipment (the amount at which it can be sold at the market: 50,000) and the recoupment of the working capital (150,000) giving terminal cash flows of $707,000
Net Present Value
The next stage is to calculate the NPV using the formula: the sum of the present value minus initial outlay. The appropriate discount rate is 12% and the present values of each year are calculated using the formula: CF/(1+rn) where CF represents the after tax cash-flow, r is the discount rate (r), and n is the number of years. The sum of the preset values is $1, 941, 106 and subtracting the initial outlay gives an NPV of $291,106.91.
Acceptance criteria
The decision rule under NPV is that “a project should be accepted when the NPV is positive (NPV>0) and reject the project if the NPV is less than zero” (Abor, 2017). Therefore, the company should accept the bicycle project because the NPV is greater than zero. A positive NPV is consistent with the goal of a firm which is maximizing wealth for the owners, and the expectation is that the project will add value to the firm.
References
Abor, J. Y. (2017). Evaluating capital investment decisions: Capital budgeting. In Entrepreneurial finance for MSMEs (pp. 293-320). New York, NY: Springer.
Gitman, L. J., Juchau, R., & Flanagan, J. (2015). Principles of managerial finance. New York, NY: Pearson Higher Education AU
Pinto, J. E., Henry, E., Robinson, T. R., & Stowe, J. D. (2015). Chapter 6. Free cash flow valuation. CFA Institute Investment Books, 2015(4), 295-360.
