Capital Budgeting and Forecasting Analysis in This Free Essay

Introduction

This report is a financial analysis of the current financial statements as well as a new project analysis using capital budgeting tools. Additionally, historical forecast methods are used in forecasting the financial statement.

Discussion and analysis

Does revenue of 25 million looks realistic?

Essentially yes. The income of 25 million in 2015 is realistic if we look after the forecast using historical methods from last two years. Below is the analysis:

Budgeted Expected

Year 2011 2012 2013 2014 2015

Revenue 11,005,208 14,497,645

Expected Growth Rate 32%

Expected Forecast 19,098,386 25,159,145 33,143,249

Budgeted Growth rate Expected

Year 2011 2012 2013 2014 2015

Revenue 11005208 14497645 32% 19571821 26421958 35669643

The analysis shows that the revenue will attain a target of 33 million with 32% growth rate as per budgeted method forecast. However the amount will be more considering the effect of new press. The analysis of the revenue using the new press is shown below. In this case, it is assumed that an additional growth rate of 35% is expected due to the effect of a new press.New Project analysisIn order to determine the returns received from an investment such as infrastructure, machinery, plant and properties in the long term, capital budgeting has to be considered. According to Anderson (2007), this approach helps determine how viable it is to undertake a particular investment and whether it is worth consideration. The same evaluation technique used in doing the analysis of the project. Investment, in this case, refers to the expenditure incurred in acquiring long term projects such as fixed assets. In other words, it is the process by which management selects fruitful management proposal. According to (Bierman, and Smidt 2006), there exist various tools useful in testing capital budgeting. These tools are efficient in analyzing the prospects of the project that are paramount in evaluating whether to accept or reject the proposals. The tools used as well as the analysis are as given below:-

Analysis using NPVNPVNPV stands for Net Present Value. The NPV involves getting the cash flows subtracted from the cash inflows (Koller, Goedhart, & Wessels, 2012). This method overcomes the disadvantage of Payback period by taking into account time value of money given as:

NPV = CF1 + CF2 +.. CFn - Co

(1+r) (1+r)2 (1+r)nWhere;

Cf Cashflows from the project

Co - Initial capital outlay

R Required rate of return

n- Period of time taken by the project

While taking into account of the effects of inflation and returns, NPV can be used in computing the present value of cash flows, as well as the value of cash flows in the future. However, there is criteria to follow. Ideally, a project may only be accepted if its NPV is positive (Giddy, 2013). In this analysis, costs of capital and required rate of return are used in carrying out the analysis. Below is the detailed assumptions and analysis:

Assumptions

Purchase year 2012

Expiry year 2019

Cost Of Capital 8%

Required Rate of Return 10%

Below is the analysis:

Year 2012 2013 2014 2015 2016 2017 2018 2019

Initial cost -950000 - - - - - - -

Cash Flow 90000 90000 90000 90000 90000 90000 90000

Net Cash Flow -950000 90000 90000 90000 90000 90000 90000 90000

NPV @ cost of Capital -481,426.69

NPV @ Rate of return -511,842.31

From the analysis, it is clear that since it is negative so the project shouldnt be accepted.

Analysis using IRR

According to Branting (1987), IRR is defined as the discount rate often used in capital budgeting which makes the NPV of all cash flows from a project equivalent to zero. It is the short form of the term internal rate of return. The decision criteria for evaluating a project using IRR approach provides for the selection of a project with the highest IRR (Holland, & Torregrosa, 2008). The project with highest IRR should be selected while holding all other factors constant. IRR is also synonymous with term "economic rate of return (ERR)."

Below is the detailed analysis of the project:

Year 2012 2013 2014 2015 2016 2017 2018 2019

Initial cost -950000

Cash Flow 90000 90000 90000 90000 90000 90000 90000

Net Cash Flow -950000 90000 90000 90000 90000 90000 90000 90000

IRR -9%

Decision criteria

The IRR is negative (-9%) implying that the project should not be accepted.

Analysis using Payback

Payback refers to the time taken by investments cash inflow to be equals cash outflow (Rstenberger, 1997). It is usually expressed in years. The rule of the thumb is to accept the project with shortest payback. Payback is oftenly used as first method of screening and selection of projects. While using this project evaluation approach, a prospective company may analyze a capital project to see whether the no. of years from the payback method meets the business target period. If a project does not meet this criterion, it should be rejected. Additionally, when the costs of the project are greater than the cash flows it generates, it should be rejected (Koller, Goedhart, & Wessels, 2012). In this case, the project should be rejected because seven years is not enough to recover the full costs of the project. Below is the detailed analysis of the investment:

Year 2012 2013 2014 2015 2016 2017 2018 2019

Initial cost -950000

Cash Flow 90000 90000 90000 90000 90000 90000 90000

Net Cash Flow -950000 90000 90000 90000 90000 90000 90000 90000

Payback -320,000.00

Future Forecasting

Future prediction is usually done using historical methods. Below, is the detailed assumptions relating to the project:

Assumptions

Revenue Growth Rate 35% due to effect of New Press

Other Growth rate

Cost of Goods Sold 31%

Gross Profit 36%

S, G & A 34%

Interest Expense 35%

Income before taxes 40%

Income taxes 40%

Net income 40%

Budgeted Growth rate Expected

Year 2011 2012 2013 2014 2015

Revenue 11005208 14497645 32% 19571821 26421958 35669643

Cost of Good Sold 9106901 11910643 31% 15577573 21029724 28390127

Gross Profit 1898307 2587002 36% 3525552 4759495 6425318

S, G & A 1045000 1405000 34% 1889019 2550176 3442737

Interest Expense 234728 316140 35% 425788.6 574814.6 775999.7

Income before taxes 618579 865862 40% 1211999 1636198 2208868

Income taxes 247432 346345 40% 484799.5 654479.3 883547.1

Net income 371147 519517 40% 727199.3 981719 1325321

The detailed forecast using the above set of assumptions given below:-

Decision criteria

The above estimate shows that revenue will reach 35 million in next three years with a profit of 1.3 million.

Recommendation and Conclusion

From the Capital Budgeting and Forecasting analysis, it is clear that management should reject the project since both NPV, and IRR and not favorable, and also the revenue expectation of 33 million seems realistic in both conditions.

References

Anderson, C. M. Jr. 2007. The capital budgeting process. Management Accounting (September): 30-32, 42

Bierman, H. and S. Smidt. 2006. The Capital Budgeting Decision. New York: Macmillan.

Branting, R. 1987. Analysis of the IRR evaluation tool.

Giddy, I. 2013. Methods of Corporate Valuation, New York University.

Holland, J., & Torregrosa, D. 2008. Capital budgeting. Washington, D.C.: Congress of the U.S., Congressional Budget Office.

Koller, T., Goedhart, M. and Wessels, D. 2012. Valuation. Wiley Publications, New York, Fifth Edition.

Rstenberger, G. 1997. The payback period rule: Its impact on innovation and economic growth. Bern: Universitat Bern, Abteilung fur Angewandte Mikrookonomie.