Pet Pamper Capital Budgeting Essay - 825 Words

Pet Pamper: Capital Budgeting (Other (Not Listed) Sample) Content: Pet Pamper Ltd.Management ReportBackground of the problemWith intense pressure to optimize the share price, Pet Pamper Ltd has identified various projects it can profitably engage in. These include M/s Smithà ¢Ã¢â€š ¬s inventory processing efficiency improvement and inventory holding time reduction projects (Projects A B), carpet and vinyl office refurbishment projects (Project C D respectively), and the water-loving dogs manufacturing project (Project E). The scope of this report revolves about the establishment of a suitable approach of systematically selecting the most suitable capital budgeting approach. With the shareholder interest in mind, the optimal capital budgeting approach selected will aim at optimizing the companyà ¢Ã¢â€š ¬s profitability. Profitability of the companyà ¢Ã¢â€š ¬s operations will lead to an ultimate increase in the earnings per share.The feasible optionsThere are various approaches to capital budgeting approaches accessible to Pet Pa mper Limited. For optimal performance, the approach selected for use should give optimal returns to the company, have minimal risk exposure for the company or lead to cost reduction. Among these approaches is the Net Present Value (NPV) approach, the Internal Rate of Return Approach and the Payback Period Approach. A further selection criterion will be based on the overall effect of the approach on the long-term profitability of the company.Synthesis of various systematic approaches 1 The Net Present Value (NPV) ApproachThis is a time-value of money based approach that evaluates the companyà ¢Ã¢â€š ¬s profitability based on an individual projectà ¢Ã¢â€š ¬s feasibility and profitability. Under the approach, the project with the highest present value of future cash inflows net of the cash outflows is considered. As an evaluation and investment measurement factor, the interest rate of return for the project is assumed to be equivalent to the risk free rate of return or the interest r ate on debt. In essence, Pet Pumperà ¢Ã¢â€š ¬s interest rate will be 12% p.a. (3,000,000/25,000,000*100%).Assumptions of the approachUnder the approach, we assume M/s Smithà ¢Ã¢â€š ¬s assumptions on the cash flows are certain and assured with negligible deviation, if any. Since the approach is anchored on the presence of cashflows (both in and outflows), the certainty of the assumed future cash in and outflows is essential as it avoids the requirement to revalue the project and further that the returns realized throughout the project life are reinvested at the same rate of return. Since the project accounting takes place at the end of the projectà ¢Ã¢â€š ¬s fiscal year and on its completion, this approach further requires prudent assumption that the cashflows are realized either at the end or the beginning of the fiscal year. A further assumption is that the impact of inflation on the project cashflows is insignificant and that the operations of the project are not subject to ta xation. This is essential as it allows for objective evaluation of all Pet Pamperà ¢Ã¢â€š ¬s projects with the projected cashflows with putting provisional budgetary allocations for inflation and taxation.Project NPVsThe NPV of the projects is computed as follows:NPV = CF0(1+r)0 + ÃŽÂ £{CFi((1+r)n} where CF0 is the initial cash outflow, r the interest rate and {CFi((1+r)n the individual net cash flows realized after the initial cash outflow of amount CFi at time i=1,2,3à ¢Ã¢â€š ¬n.Project ANPV = -5.5(1.12)0+4.3(1.12)1+0.2(1.12)2+3.6(1.12)3 = $4.6246208 M.Project BNPV = -23(1.12)0+16(1.12)1+0.8(1.12)2+14.5(1.12)3= 16.294976 M.Project C DFor project C D, there are no directly positive cash flows associated with the project. Therefore, they cannot be evaluated by the NPV approach.Project EUnder the water-loving dogs manufacturing project, Pet Pamper Ltd obtains a 5-year licensing from the shark and crocodile developers at a $5 royalty per unit sold. The initial sale price per p roduct will be $200.Prior to the onset, a market pretesting of the product will also be done at an initial marketing cost of $30,000.Year Annual Sales Revenue Royalties/fees Marketing cost Net Profit before tax 0 -25,500,000 - -100,000 -30,000 -25,630,000 1 175,000 35,000,000 875,000 1,000,000 33,125,000 2 200,000 40,000,000 1,000,000 600,000 38,400,000 3 150,000 30,000,000 750,000 300,000 28,950,000 4 60,000 12,000,000 300,000 300,000 11,400,000 5 35,000 7,000,000 175,000 100,000 6,725,000 Thus, the NPV for Project E will be:NPV = -25.63(1.12)0+33.125(1.12)1+38.4(1.12)2+28.95(1.12)3+11.4(1.12)4+6.725(1.12)5 =$130,101,494.1RemarkBy NPV approach, project A, B and E have NPVs0, thus viable. However, project E would be accepted as it has the highest net present value. 2 The Internal Rate of Return (IRR) ApproachThe internal rate of return, i, is the interest rate at which the project repays its initial investment as to match the initial cash outflow. I.e. At the interest rate, i, the N PV of the project yields to zero. With its core merit being that it highlights the return resulting from the project, if i is higher than the cost of capital, the project is adopted. Else, it is rejected. Here, the project is only accepted is the rate of return, i12%.Project AIRR = -5.5(1+i)0+4.3(1+i)1+0.2(1+i)2+3.6(1+i)3 = 0Trying i=10%,IRR (10%) = -25.63(1.1)0+33.125(1.1)1+38.4(1.1)2+28.95(1.1)3+11.4(1.1)4+6.725(1.1)5 =$123.33253698Tryingi=5%,IRR (5%) = = -25.63(1.05)0+33.125(1.05)1+38.4(1.05)2+28.95(1.05)3+11.4(1.05)4+6.725(1.05)5 =$107.74402585Thus, i must be below 5%.By linear interpolation,Project BIRR = -23(1+i)0+16(1+i)1+0.8(1+i)2+14.5(1+i)3 = 0Trying i=10%,IRR (10%) = -23(1.10)0+16(1.10)1+0.8(1.10)2+14.5(1.10)3 = $4.2636Trying i=5%,IRR (5%) = -23(1.05)0+16(1.05)1+0.8(1.05)2+14.5(1.05)3 = 3.40295Thus, i must be below 5%. By linear interpolation, i=Project C DFor project C D, there are no directly positive cash flows associated with the project. Therefore, they cannot be ev aluated by the IRR approach.Project EIRR = -25.63(1+i)0+33.125(1+i)1+38.4(1+i)2+28.95(1+i)3+11.4(1+i4+6.725(1+i)5Trying i=10%,IRR (10%) = -25.63(1.1)0+33.125(1.1)1+38.4(1.1)2+28.95(1.1)3+11.4(1.1)4+6.725(1.1)5 =$123.33253698Trying i=5%,IRR (5%) = = -25.63(1.05)0+33.125(1.05)1+38.4(1.05)2+28.95(1.05)3+11.4(1.05)4+6.725(1.05)5 =$107.74402585Thus, i must be below 5%.By linear interpolation, 3 The Payback Period ApproachFor firms with urgent need for share price optimization, there is need to have high cash conversion ratio throughout the various projects they undertake. Pet Pamper shareholders expect an improvement in the dividend payout for their shares. An efficient way of maintaining a balance between capital projects, its profitability and conversion ratio is by investing in projects with short and certain initial investment recouping period. This way, Pet Pamper can fund most other activities with longer project life. In essence, the payback time is the time it takes for Pet Pampe r to have the cash inflows generated from a project match the projectà ¢Ã¢â€š ¬s initial cash outflow (Singh, Jain, Yadav, 2003).Assumptions of the Payback period approachUnder this approach, it is assumed that there are no significant cash flows after they payback period of the project. With this said, it becomes challenging in determining the profitability of a project with certainty under the approach (ActEd, 2015).Project Payback periodsProject AYear 0 1 2 3 Cashflow ($ Millions) (5.5) 4.3 0.2 3.6 Cumulative cashflows (5.5) (1.2) (1.0) 2.6 Thus, the payback period = {2 + (1.0/3.6)} years = 2.2778yrsProject BYear 0 1 2 3