Executive Summary
In this report, a detailed analysis has been undertaken to understand the concepts of capital budgeting techniques, and how the cash budget is formed and the break-even analysis is carried out. In the present case study, Binary corps are advised to accept the project on the basis of the parameters that have been undertaken and the cash is negative in case of the second case of Telco as the sales are entirely on credit basis. Furthermore, the issues arising from using such models to calculate the value has also been determined, and the recommendations have been provided to improve the results.
Table of Contents
Overview
Investment appraisal is a group of methods used to identify the attractiveness of an investment. Generally, the purpose of investment appraisal is to find out the feasibility of the program or portfolio decisions and the return they generate. Capital budgeting is one of the techniques that are used by the business to evaluate the proposals that shall be selected for long term viability. This process is useful in creating the quantitative view of each proposed fixed asset investment, which helps in creating a rational basis. In order to find out if the plant and machinery, new products are worth funding or not, capital appraisal techniques are used to find out the same. Investment appraisal is crucial for traders because it is a form of fundamental analysis and, as such, it is capable of showing a trader whether a stock or a company has long-term potential based on the profitability of its future projects and endeavors.
Literature Review
According to Gallo, 2016, there are several techniques that can be used such as net present value, internal rate of return and payback period. In the present case, Binary Corps shall accept the proposal. This is because the net present value of the company is positive at $3514071; refer to Appendix 1.
This implies that this proposal will increase the future benefits for Binary Corps. The net present value method is the method that is used on a frequent basis but the other parameters shall also be checked by the company. The time value of money is the principle that says that the value of the money at present is more valuable than it is in the future because it has longer to earn interest. Cash inflows and outflows are adjusted according to the principle of the time value of money, taking available interest rates into account.
In the opinion of Abor, 2017, the other parameters are like the payback period and the internal rate of return. The payback period is the period which defines the ability in terms of the time period of the company, of how well the company is able to recover the cost of the initial investment. The ideal payback shall be short enough for the selection. The payback period in the present scenario is 5.07 years and this implies that the company can recover the initial costs in 5 years and 0.7 months; refer Appendix 1.
Since this method is also used on regular basis there are certain factors that are not beneficial from the point of view of the industry and hence, there are certain limitations associated with the payback period which have been listed below. However, in the perception of Zhao and Zhang, 2019 while making the calculation of the payback period, the net incremental cash flows are usually not adjusted for the time value of money. This means that the initial cost and the annual cash flows are deemed to be the same and hence, the wrong results are incorporated. The second major drawback is the incremental cash flows received after the payback period is ignored.Payback period Cash Flows Cumulative Cash Flows0$ (3,500,000.000)$ (3,500,000.000)1$ (255,937.500)$ (3,755,937.500)2$ 731,146.365$ (3,024,791.135)3$ 918,659.177$ (2,106,131.958)4$ 1,078,696.610$ (1,027,435.348)5$ 963,121.974$ (64,313.374)6$ 876,750.487$ 812,437.1127$ 782,812.935$ 1,595,250.0478$ 698,940.120$ 2,294,190.1679$ 624,053.679$ 2,918,243.84610$ 595,827.573$ 3,514,071.4195.07years
In the view of Bornholt, 2017 the next technique that could be used is the internal rate of return that is used as a metric in the field of capital budgeting to estimate the overall profitability of the potential investments. The companies invest in those projects whose internal rate of return is higher than the cost of capital. In this scenario, the internal rate of return is 13.41% which is higher than the cost of capital. The major limitations that are associated with the internal rate of return are it is a measure of absolute value but the cash flows are conventional. Further, the internal rate of return technique is a technique that ignores factors like project duration, future costs or size of the project.Internal Rate of return Cash Flows 0$ (3,500,000.000)1$ (255,937.500)2$ 731,146.3653$ 918,659.1774$ 1,078,696.6105$ 963,121.9746$ 876,750.4877$ 782,812.9358$ 698,940.1209$ 624,053.67910$ 595,827.573 13.41%
Hence, from the overall analysis the final results on which the company arrives at is the acceptance of the proposal as the net present value is positive, the internal rate of return in higher than the cost of capital and the payback period is just 5 years to cover the huge initial cost, hence the company shall accept the project as it will provide the future benefits.
Sources of funding
There are different types of sources of funds prevailing in the market and some of the examples are debt, equity, working capital loans, letter of credit venture funding and a lot more.
The debt financing is the financing that means a borrowing of the funds from external parties, over a fixed period for a pre-determined rate. There are certain advantages that are associated with the debt such as ownership and control of the power. The controlling interests are also not lost if debt financing has opted. The major decisions are taken by the debenture holders and while distributing the profits, the debt holders are considered in the first place. The most important tax feature of the debentures is that they are prone to tax deductions which might not have a huge impact on the business but can definitely change the net profits of the business.
Equity is another form of the sources of funds that can be acquired by the business which are willing to take risks. Equity financing may be in the form of close partnerships through crowdfunding platforms, capital firms and finally in the form of IPO. There are certain benefits that are also associated with the financing through equity and in that case the first and the foremost would be no fixed payments, rather it depends on the value of the stock. The equity financing alone has more potential in comparison to the debt financing and this fast pace growth giver investment. Flexibility in distributions is the biggest draw to using equity and hence, equity financing tends to be beneficial. At times it is not just about money rather, it is about a relationship that can bring in the equity partners which possibly means bringing invested interest of long term nature.
With pros comes the cons of the financing and hence the cons of the debentures and the equity are also discussed below in detail to get an insight of all the aspects of both the funding sources. The primary fear of giving up equity is the loss of the power and the ownership of the business. The time-consuming process of equity is not feasible when the soaking up of the funds is too complex to handle. On the other hand, when compared with equity, debt financing also has some demerits such as it requires the repayment no matter what the situations are, even when you are out of the cash. Too much of the financial leverage through debt can impact the profitability and the valuation of the business.
Cash Budgeting
According to DeFranco and Schmidgall, 2017, the budget which is famous for incorporating revenue and capital items, such a process is termed as cash budgeting. A cash budget is a detailed budget of income and cash expenditure and it must be prepared within a proper format in which the actual position is to be presented. The cash budget can be prepared in various manners such as monthly yearly or quarterly as well. The major areas for which the cash budget is actually prepared is to get an insight of liquidity and it must reflect variance between the starting and the ending balances of both the debtors as well as the creditors of the company. The cash budget basically acts as a mirror that displays the movement of the cash through the operational budgets and the profits.
In the present scenario, the opening balance of the cash is $130000 and the expenses of the December month are $441653 and these results in the negative cash balance. The Positive figure of $42997 cash balance reflects the company able to pay back the expenses. Hence, the proposal is profitable and feasible.
On a positive note, and according to Wildavsky, 2017, while the cash budgeting is taken into consideration the following points are taken into consideration such as the time period of the credit that is allowed to the customers, the times period received by the suppliers, payments of the tax dividends and the impact of the transaction which are of non-cash nature. The cash budgeting takes place through different methods such as adjusted income method, adjusted balance sheet method and receipts and payment method. Hence, the cash budget serves as an important financial tool in analyzing the financial performance of the company.
Breakeven analysis
In the idea of Krishna, Pandey and Thimmalapura, 2017, the breakeven analysis is the analysis that defines at what point your company, or a new product or service, will be profitable. In the other terms, it’s a financial calculation used to evaluate the number of products or services which is minimum to be produced to arrive at the situation of the no profit no loss zone. This is a situation where there is no revenue and yet all costs can be covered without any hassle. There are four major scenarios where the break-even analysis is useful such as while starting a new business, creating a product, when the new sales channel has been added and when the business model has been changed for the betterment of the business.
The formula of the breakeven analysis is = Fixed costs / Contribution per unit
For example, a break-even analysis is used to find out how many mobile phones are required to be sold in order to settle the warehousing costs. Anything which is sold beyond the break-even point is the point that adds to the profits.ParticularsAmountTotal Fixed Costs $ 205,000.00Contribution per unit$ 654.44Break-even analysis 313
While the views of Sun, et al 2018, suggest that the breakeven analysis has certain advantages such as price smarter, cover fixed costs and also helps in catching the missing expenses. The setting of revenue targets also helps in making smart decisions and this also helps in funding the overall business. As per the current scenario, the breakeven unit that is required to be produced is 313 units.
Issues
As per the thoughts of Van Helden and Reichard, 2018, the top three issues that come across while analyzing the models are the ignorance of the concept of the time value of money while taking the decision regarding the investment appraisal technique and the ignorance of the non-cash items while making the cash budgets. At times when the projects are mutually inclusive, it becomes difficult to arrive at a decision. The major issues can be analyzed when the calculation of the net present value comes into the picture as the net present value method is not easy to calculate. The formation of the cash budget and the break-even analysis can mix up when the wrong figures are taken and hence, it becomes cumbersome for an individual to understand the true position of the proposal and the cash budgets.
Recommendations and conclusion
After analyzing the position of both the companies in detail it can be analyzed that while making the analysis of whether the project shall be accepted or not, the final result was to accept the project, but since the cash in hand is quite low the company must either bring in the capital through the funds discussed above or must make the sales in cash to generate some revenue. The project will be feasible. In the case study two, the subsidiary of Binary Corps, the cash is positive, thus no problem with the new profitable investment. Henceforth, from the above analysis, it can be concluded that the project is worthy; however, Telcorp is required to make additional investments to bring in more cash by reducing the average unit cost from $140 to $125 to cover a higher profit margin for the company and with a good net safety margin ratio. It is also recommended to the company not to rely on just one investment appraisal technique while taking the decisions, rather a combination of the three or four techniques shall be used to arrive at a proper conclusion.
CritiqueThis is a profitable business & the Break Event is 313 Sales unit.
Thus the history of sales units always exceeds 313, therefore it is a feasible business to do.The company has stocked up sufficient inventory through purchase and leftover
Inventory from the previous month.However, the sales figure is able to support the inventory and purchases as the Gross
Profit shows Profitable form Oct 2019 to Feb 2020.Although the sales went down in the Month of December 2019,
Sales pick up very soon at the beginning of the next year 2020 Jan.
References
Abor, J.Y., 2017. Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.
Bornholt, G., 2017. What is an investment project’s implied rate of return?. Abacus, 53(4), pp.513-526.
DeFranco, A.L. and Schmidgall, R.S., 2017. Cash Budgets, Controls, and Management in Clubs. The Journal of Hospitality Financial Management, 25(2), pp.112-122.
Gallo, A., 2016. A refresher on internal rate of return. Harvard Business Review Digital Articles, 2.
Krishna, K.M., Pandey, N.K. and Thimmalapura, S., 2017. Break-even analysis and economic viability of powertrain electrification—An analytical approach. In 2017 IEEE Transportation Electrification Conference (ITEC-India) (pp. 1-6). IEEE.
Sun, M., Chang, C.L., Zhang, J., Mehmani, A. and Culligan, P., 2018, April. Break-even analysis of battery energy storage in buildings considering time-of-use rates. In 2018 IEEE Green Technologies Conference (GreenTech) (pp. 95-99). IEEE.
Van Helden, J. and Reichard, C., 2018. Cash or accruals for budgeting? Why some governments in Europe changed their budgeting mode and others not. OECD Journal on Budgeting, 18(1), pp.91-113.
Zhao, R. and Zhang, X., 2019. Analysis of Investment Decisions of SMEs. In 2019 International Conference on Management, Education Technology and Economics (ICMETE 2019). Atlantis Press.
Wildavsky, A., 2017. Budgeting and governing. Routledge.
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