Capital Budgeting Case Egret Printing & Publishing Company

Instructor: Mr. Sabin Bikram Panta

Submitted By: Group 3

Shivshankar Yadav (12336)

9/3/2012

Theory and Case Background:

The term capital budgeting refers to the process of decision making by which firms evaluate the
purchase of major fixed assets, including building, machineries, and equipment. Capital budgeting describes the firms formal planning process for the acquisition and investment of capital and results in capital budget that is the firms formal plan for the expenditure of money to purchase new fixed asset for expansion or replacement of business. Egret printing and publishing company is a family owned company established by Jhon and Keith in 1956. Patrick Hill joined the firm in 1979 in accounting department. As being in this department he has responsibility for both internal and external financial decision. Egret is an all equity capital structured company. It was a success company specially, in printing business. It has also made a investment in a diversified business named local video text service. Over one half of the systems subscribers pay for the video text service. Belford had identified four major investment proposals for his firms internal fund 1.5 million. The four projects are as follows: Project A: Major Plant Expansion: This project has been designed to alleviate the capacity problem by constructing a new wing on the main plant. This additional space would allow to hold a greater vriety of paper stock in inventory and to reposition its various processes for a more efficient work flow. Project B: Alternative Plan for Plant Expansion This project was an alternative of project A. it can be installed much more quickly and will allow Egret to take several major printing jobs in the next few years. Project C: Purchase of New Press This is a dependence project on A or B. so, the existence of this project dont affect the future cash flow for project A or B. it is basically for covering the extra market of high quality color calendar demanders. Project D: Upgrade of Egrets Video Text Service This is independent project toward video test service in which the firm has made investment since 1991 and because the number of existing as well as new subscribers has fallen, it is inherent to invest in this project.

Significance of this study:

This case as well as applied concept In this case really contributes more many knowledge to us for making decision on selecting appropriate project to invest. Let us deal its contribution point wise. To evaluate projects based on future cash flow and its impact on wealth maximization To use various method of evaluation and also to find the best approach of evaluation

To compare various types of projects like mutual exclusive project, dependent project, expansion project. To compare the projects of size disparity, time disparity. To relate the theoretical concepts in practical life. To make decision of capital budgeting in fallout of capital rationing situation. To know the impact of qualitative factors in decision making for capital budgeting To know the use of appropriate cost of capital for calculation NPV. To know the effect of time value of money in selection criteria To know the impact of change in cost of capital to decision criteria.

Question 1: Determine the payback, net present value (NPV) and internal rate of return (IRR) for each project, using both 15 and 21% discount rates. Rank the investment proposals considering the capital budget of $1.5 million. Which projects should the company choose and why? Which discount rate is more appropriate? (Note that project A and B are mutually exclusive).

Calculation part derived from Excel

project A
Year 0 1 2 3 4 5 6 7 8 9 10 NPV@15% PV@21% IRR Cash Flow -500000 136000 136000 136000 618800

Project B
Cash Flow -500000 370000 270000 155000 49000

Project C
Cash Flow -1000000 323000 323000 323000 323000 323000 323000 323000 323000 323000 323000 $621,062.27 $309,467.18 29.9475%

Project D
Cash Flow -500000 175000 175000 175000 175000 175000

$164,319.52 $70,729.75 26.6169%

$155,828.85 $100,551.08 34.996%

$86,627.14 $12,047.26 22.106292%

Note: the above answers are derived from direct use of Excel formula thats why we dont put any formula and process of calculation here.

Ranking of the Projects

PBP

NPV

IRR

Rank
Regular PBP I II III IV B(1.48) D(2.86) C(3.09) A(3.15) Disc. PBP@15% B(1.87) A(3.54) D(4.00) C(4.49) Disc. PBP@21% B(2.11) A(3.75) D(4.82) C(5.53) 15% 21%

C($621,062.27) C($309,467.18) A($164,319.52) B($100,551.08) B($155,828.85) D($86,627.14) A($70,729.75) D($12,047.26)

B(34.996%) C(29.947%) A(26.617%) D(22.106%)

Decision based on Payback Given that Erget has only 1.5 million to invest, it cannot select all the projects. Moreover, mutual exclusivity of project A& B do not let to choose both of them. The next constraint is that project C is not feasible when either A or B is not chosen but choosing A or B do not make compulsion to choose project C. Based on regular payback method, if we want a high liquidity and certainty in our cash flow during first few years then project B is better than A. Here project B is best among all other projects as well. So, project B is the best choice in terms of payback. Similarly, Project D comes in second ranking. Because of financing constraints we cannot choose both D & C because B is already chosen. So, B and D can be chosen if we prioritize payback. But choosing B and D will only utilize 1 million of fund available. So, remaining fund cant be allocated for other project C. However if the firm chooses B and C then it has to compromise on payback for the maximum allocation of available fund. Hence, choosing B & D is appropriate if the company prioritize payback without considering allocating all available fund but if prioritize utilization more than payback alone choosing B & C is appropriate. Decision based on discounted payback The company has to choose project B&D if attaining minimum payback is the only objective and allocating all fund is not compulsion but if it the objective is to minimize payback period as well as utilize all the investment fund then it should choose project B&C. Here decision is same for both the rates because the ranking is same at both rates.

Decision based on Net Present Value @15 % Based on NPV at 15%, it is crystal clear that C & A is the optimum choice that provides positive and higher NPV and at the same time utilizes all internally available funds. Project C is chosen because it provides the highest NPV. But to choose C, we must choose either A or B because of their dependency. Hence, we selected project A that provides second highest NPV at 15%. Decision based on Net Present Value @21 % Based on NPV at 21%, it can be seen that project C & B is the optimum choice because this choice provides highest positive NPV and at the same time utilizes all internally available funds. Project C is selected because it provides the highest NPV. But to choose C, we must choose either A or B (they are mutually exclusive) so we chose project B that comes in second ranking in NPV. Decision based on IRR Based on IRR, project B & C are at the optimum choice. It is because project B provides the highest IRR whereas project C provides second highest IRR. Both projects are sufficient to utilize all the internally available funds and also fulfill the criteria of dependency. Based on above discussion the following synopsis is derived
PBP Regular PBP Decision B & D ( if payback is single criterion) B&C (if fund is to be fully utilized) Disc. PBP B & D ( if payback is single criterion) B&C (if fund is to be fully utilized) 15% A&C NPV 21% B&C B&C IRR

Recommendation & Final decision

It is recommended that the company should go with project B and project C (ignoring the effect of difference in life of the projects). It is because both NPV at 21% and IRR are higher in these two projects. We do not consider payback as decision criteria because of the following issues1. It does not say which project maximizes shareholders value, which means it ignores the projects MVA. 2. Regular payback ignores time value of money. 3. It ignores the payoff after the cut-off date. 4. It ignores project size. In this decision IRR of both projects B & C are among the highest one. So, they add a positive point to our decision. But still, we emphasize on NPV while making our decision. If IRR was not congruent with NPV values, then we would have gone with NPV. It is because of the following disadvantages of IRR1. It does not present clear picture about value addition but shareholders value maximization is the ultimate goal of financial decision. 2. It does not ensure that highest IRR means highest profitability 3. The reinvestment assumption is the same IRR rate which is not realistic.

Why 21% is the appropriate discount rate?

Given that the opportunity cost on outside investment is 21%, it is certain that Belfords are investing in these projects by forgoing the alternative investment possibilities that could generate 21% returns. Since these new projects are not started yet and Belfords can rethink and take out the available 1.5 million for other alternatives, it is appropriate to use 21%. The rate of 15% is the nominal book rate but an investment is considered a good decision if it provides extra returns than the possible investments alternatives having similar risk available in the market. Here, let us assume Belfords return on project A is 18%, then it is worthless for Belford to invest in project A when he can easily invest his money at other projects of similar risk that are providing 21% returns in the market. Companys WACC of 15% is irrelevant here in project decision making. When the investors learn that they can earn 21% return on similar risky projects, then from the rational judgment also we can say that their minimum requirement in this project will be 21%. Thus, 21% rate is the appropriate rate. NPV of project B & C are among the highest in the available alternatives at this rate. These two choices are possible and can utilize the entire available 1.5 million funds. Hence project B & C are the most appropriate choices.

Question 2: Do you find anything wrong in choosing the projects based on pay back, NPV and IRR as stated above? What suggestions can be made to the company? How should be the projects with unequal lives dealt with? Determine equivalent annuity (EAA) for each project, and based on the calculations, which projects should Egret printing and publishing company accept for the coming year and why? Flaws in decision of QN 1 Project choice based on payback, NPV and IRR are not always consistent. They may give different indications about the projects financial characteristics. Moreover our decision on different age of projects cant be sufficed by calculating NPV without taking consideration of project life. As stated above in Qn 1, based on the payback period the choice was B and C (if full utilization of fund is prioritized) and B and D (is payback is only the decision criteria). Whereas based on NPV @15 %, choice was project A and C and at NPV @21 % the choice was project B and C. Similarly based on IRR, choice was project B and C. But all these choices do not take consideration of life of the project. If life of the project is taken into the account then choices may alter. The company can be suggested to calculate the Equivalent Annual Annuity (EAA) by eliminating the effect of the life of the project. EAA will give the average annual return that each project will provide. So comparing the same annual return is realistic. But we should equally take care on whether the given annual return can be replicated by short life projects in the same way. If the short life project cant replicate this EAA, then managerial judgments should be taken to trade off between choosing high annual returns over short time or relatively small returns over long period of time. Project with unequal lives can be dealt with two methods that are: (i) (ii) Replacement Chain Method Equivalent Annuity Method

Because of added difficulty to calculate replacement chain method we go with equivalent annuity method. The EAA are calculated below. EAA @ 15 % 21 % Project A 57555 27841 Project B 54581 39580 Project C 123747 76334 Project D 25841 4117

Based on EAA, Project B and Project C are the most lucrative ones. Here again we take 21% discount rate as a decision criteria. It is because 21% is the opportunity cost of capital. Anything added beyond 21% return is the actual return over available investments for the Belford brothers.

Here project C added the most value and to fulfill feasibility constraint of choosing project C, project D is obviously discarded and project B is the second best alternative. Beside good NPV of project B, it can be seen clearly that NPV of project be is relatively stable than that of project A. Moreover projects B and C also fulfill the requirement to invest 1.5 million of funds. Question 3: Draw a graph of NPV versus discount rate for projects A and B (a present value profile) using, in part, your answers for the IRR and NPV in question 1. Determine the crossover rate and discuss which project appears to be superior? Why?

Calculation of Crossover rate

Year project A (CF) -500000 136000 136000 136000 618800 Project B (CF) -500000 370000 270000 155000 49000 Diff.(CF) PVIF@16% PV PVIF@17% PV

0 1 2 3 4

0 -234000 -134000 -19000 569800

1 0.862 0.7431 0.6407 0.5523

0 -201708 -99575.4 -12173.3 314700.54 1243.84

1 0.8547 0.7305 0.6243 0.5336

[[[[[

0 -199999.8 -97887 -11861.7 304045.28 -5703.22

IRR= LR+

NPV LR ( HR LR ) = 16.17% NPV LR NPV HR

Present Value Profile

$600,000.00 $500,000.00 $400,000.00 $300,000.00 $200,000.00 $100,000.00 $0.00 ($100,000.00) ($200,000.00) 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% project A's NPV project B's NPV

From the crossover chart, it is found that the crossover rate is 16.17 %. It means both the project have same NPV i.e. 144320 at this rate. Strictly from quantitative view, below the crossover rate, Project A is better whereas above the crossover rate, Project B is better in terms of NPV. The relative stability of NPV of project B over project A may be added factor that will provide us qualitative reason to choose project B at some rate below crossover rate. Not only this, Project B is relatively stable. It is because the significant portion of cash inflow of project B occurs at the beginning years whereas the highest cash flow of project A occurs at the end of year 4. Therefore the fluctuation on WACC will also have less impact on the Project B whereas project A is highly sensitive. IRR also supports project B but IRR is not a sole determinant in the decision to select project B and it is NPV that matters most. In this case, Project B is our obvious choice because the required rate is 21 % which is above crossover rate where NPV is higher for project B than project A. The conflict only arises in choosing project if the required rate drops below crossover rate. In that case we may choose project A if there is certainty that the required rate will not cross the crossover rate significantly during the project life. Otherwise project B is best. Question 9: The case states that Project C would be feasible unless either Project A or B was also accepted. What is the implication of this statement on the current capital budgeting analysis? Do you think that the way Project C is handled earlier in the case is valid? Why or why not? Project C, its characteristics and way of handling it From the case, we can easily state that project C is not a stand-alone project. It is dependent upon either project A or project B. So, project A and project B create positive spillover effect (positive externality) on project C. But the project C has no any side effect on viability and profitability of project A and project B. Hence, project A and B are independent upon C whereas project C is dependent on either of them. Project A and project B talks about the expansion of plant whereas plant C talks about the purchase of new plant. Unless there is expansion to reduce the bottleneck of space availability, a new plant under project C could not be incorporated. Hence feasibility of project C stems on the acceptance of either of project A or project B. The way project C is handled is not quite scientific while ranking the projects though the decision taken in question number 2 is correct. In this type of situation, it is good to take dependent projects as a single alternative and deal as a joint project. Here the number of options to rank should have been 5 and they are: project A, project B, project A&C, project B&C and project D. The cash flow and project outlay of the joint project should have been combined. Here project C has reduced the alternatives. It made the combination of project C and project D as unviable alternative. So, dependency of the project should have been treated.

In finding EAA also, we should treat the project A&C and project B&C as a combined project and ranked accordingly. While taking decision to choose the project the dependency among project is considered, so final decision is the same. But the way the projects are ranked is not realistic. When we cant choose the projects according to their ranking because of their dependency, it was not relevant in our decision making. Hence dependent projects are to be treated as a single joint project and maintained their profile accordingly. Question 10: Do you think the quantitative measures alone are important in capital budgeting evaluation? What qualitative factors could also be important in capital budgeting evaluation? Role of qualitative factors No, the quantitative measures are not the straightjacket to rely upon. It only assists on managerial decisions. They provide the facts and figures and back up proof for manager to prove their decisions to be rational. But unless the qualitative aspects are evaluated, the evaluation for capital budgeting decision is incomplete. The important qualitative factors on capital budgeting evaluation can be: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) Effectiveness of forecast of cash flow and discount rate Time for installation and ready for working SWOT analysis Political, Economic, Socio cultural and technological (PEST) analysis Competitors analysis Alignment with mission, vision, corporate strategies and strategic fit Reinvestment opportunities and threats Effect on capital structure, dividend policy and working capital Management ability to carry out the project Matching the project with the corporate culture Stakeholders acceptance Projects scope over facilitating future growth

In this case the management has to take care of various qualitative factors while deciding to carry out a project. First of all it should check the accuracy of the numbers in cash flow estimation and discount rate. Whether the given cash flow estimates is probable and in what confidence limit we can ascertain that the cash flow is likely has to be tested upon. Similarly manager should know whether 21% investment available in market is for short term or a long term that continues with the investment horizon or not. The manager should also access the strength and weakness of the firm in carrying out the project as well as the probable threats or opportunities that the specific project carries. For example, if

new technology is introduced in the printing market then the expansion of previous plant may not recover its cost before it go obsolete. Similarly, the company thinks that demand of the printing will go high and competition is not price focused so expansion will not reduce its capacity neither profit, but there are likely chances that the competitors are also going with expansion decision and the industry may face cut throat price competition in the near future reducing its cash flow forecasts. The various political, legal, technological and socio cultural aspects also affect the market conditions. For example, the law may change and impose high taxation on printing industry to uplift paperless system, it will affect this business. The up gradation of the proposed video text service may bounce the company from its current corporate strategy of focusing into printing and publishing business. It may affect and mislead the customers about what the company is all about. Company may find difficulty to draft its mission and create the strategic fit. The most important qualitative decision is about the reinvestment rate and reinvestment opportunities that will be available after the project is over. We have assumed that the cost of funds (opportunity cost) will be same in all the years, but how much likely is that assumption? In reality, economy moves through ups and downs. The business cycle will not let the cost remain stable. Similarly we have also assumed that the short run project rate can be replicated. But the chances of getting similar return and similar nature of projects is unlikely. The capital budgeting decision affects all the other decisions like dividend policy, working capital, etc of the firm. For example, if project A is chosen instead of project B, the company will not be able to distribute dividends in its first few years as much as if it had chosen project B. Certainly it hampers the dividend policy of the firm. So, to align with the prevailing dividend policy, company may change its decision while selecting projects. Management may not be able to carry out some projects though the project seems to be technically and financially viable. In this case, the incompetency of management may lie here if the company chose to go for project C which is new to the company. Peoples problem should also be considered while making capital budgeting decision. The resistance by the employees to carry out new project may cause the viable project to fail. Similarly the concerned stakeholders should buy-in the project. In this case if Belford brothers disagree to carry out any project, then it will be nightmare for Patrick Hill to make them accept the proposal. Sometimes project is undertaken though it is less profitable but it has scope to add value to the company in other ways. Given in this case if undertaking project C creates the company a platform to attract new group of customers like wildlife and natural societies people, then the

company may find that in future these customers can be catered with other products that could be profitable. So, though this project is less profitable, company may decide to go with it. There can be numerous other qualitative reasons why company may undertake a project. Quantitative analysis just adds value in decision making. Many times it supports decision taken but sometimes decision may turn around though quantitative analysis gives a go ahead nod. So, In a nutshell, quantitative methods should be considered as an aid to informed decision but not as substitute for sound managerial judgment.

Referrences: Eugene F, Brigham/ Michael c. Ehrahardt (Financial Management) Khan & Jain (Financial Management)