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Capital Budgeting Methods

And Capital Investment Decisions



Based on
Rainbow Embroidery Limited

Submitted to:
Md. Jahangir Alam
Professor, IBA, University of Dhaka
Submitted by:
Group 12

June 23, 2013
June 23, 2013
Dr. Md. Jahangir Alam
Professor
Institute of Business Administration
University of Dhaka
Subject: Letter of Transmittal
Dear Sir,
We are pleased to submit this report to you as a requirement to our Financial Management I
course. In this report, we have used your lessons and guidance to explicate Capital Budgeting
Methods and Capital Investment Decisions in Rainbow Embroidery Limiteds Project.
We hope that every aspect of the report meets your expectations and are in accordance to your
instructions. We will be glad to answer any queries regarding the analysis of the project and the
contents of the report.
Sincerely,
Group 12, Section: B
BBA 20
th
Batch
Institute of Business Administration
University of Dhaka
Name Roll Number Signature
Sudipta Saha Turja (ZR 95) _______________
Musharrat Rahman Chandrika (RH 97) _______________
Hikmat Kabir (ZR 99) _______________
Sayem Faruk (ZR 128) _______________


Acknowledgements

First of all, we would like to thank the Almighty for giving us the ability to complete our report
on time. We would then like to convey our thanks to our respected and beloved course
instructor, Dr. Md. Jahangir Alam for his guidance throughout the making of the report. His
supervision and support have helped us a lot in the making of our report and it goes without
saying that the lessons he has taught us shall remain invaluable throughout our entire lives and
will immensely aid us in our respective careers. Lastly, we would also like to express our
gratitude towards Rainbow Embroidery for providing us with the foundation to build our
project.
Finally, we would like to stress again that whatever we have learnt while making this report will
be etched in our memories as a monumental experience and will aid us incalculably throughout
our lives.


Executive Summary

This report is done in order to determine the profitability and feasibility of a new project that is
to be undertaken by Rainbow Embroidery. Rainbow Embroidery is considered a leader among
its contemporaries when it comes to embroidered garments with Rainbow completing orders
for the jerseys of famous teams like FC Barcelona, Juventus, etc. The information needed to
facilitate the findings of the report were both obtained from primary sources, i.e. Rainbow itself
and other secondary sources such as the lectures provided to us by our honourable course
professor Professor Dr. Md. Jahangir Alam. However, limitations such as time and lack of some
proper information outlets such as a working website has hampered the ability of this report to
reach its full potential.
Rainbow Embroideries needs to expand the volume of its work in order to keep up with
competition both home and abroad. As such, they are considering the practicability of buying
30 machines composed of three different models. These machines are to be used for 10 years
with an estimated required rate of return at 16% after which they shall be sold off.
In order to ascertain the acceptability of this project, much extensive calculations were done in
order to come up with an accurate pro forma income statement and pro forma cash statement.
With the help of those, essential figures such as the Net Present Value, Profitability Index and
Internal Rate of Return were determined and then scrutinized in order to determine whether
the company should accept the project or not. At the end, it was decided that the company
should let go off this project since all three of the required figures were deemed to be
unsatisfactory as per the companys requirement.


Table of Contents

Topic No. Topics Page No.
1.0
1.1
1.2
1.3
1.4
1.5
INTRODUCTION
Origin of the Report
Objectives of the Report
Scope of the Report
Methodology Used
Limitations
1 2
1
1
1
1
2
2.0 COMPANY AND FACTORY OVERVIEW 3 4
3.0 PROJECT OVERVIEW 5 - 6
4.0

4.1
4.2
CAPITAL BUDGETING METHODS AND CAPITAL
INVESTMENT DECISIONS
Capital Budgeting Methods
Capital Investment Decisions
7 8

7
8
5.0 ANALYSIS OF THE PROJECT 9 - 19
6.0 RECOMMENDATION 20
7.0 BIBLIOGRAPHY 21



1


1.0 Introduction
1.1 Origin of the Report
The report was assigned to us as a part of the group assignment in Financial Management I
course by our course instructor Dr. Md. Jahangir Alam. The topic was assigned to us by the
course instructor and the company was selected by submitting a proposal to him.
1.2 Objectives of the Report
To understand the applications of the methods of capital budgeting and capital
investment decisions
To relate the basic financial terms with real life industrial activities
To provide recommendations based on the analysis
1.3 Scope of the Report
The report mainly focuses on four things:
1. The overview of Rainbow Embroidery as a company and the overview of the project
2. The financial information regarding the project
3. The analysis of the financial information using capital budgeting methods (Net Present
Value, Internal Rate of Return and Profitability Index)
4. The recommendation that will be provided in accordance to the results of the analysis
1.4 Methodology Used
We have used both primary and secondary sources of data to make the necessary analysis
shown in the report.
1. Primary source: We have contacted one of the members of the board of directors of
Rainbow Embroidery, Mr. Joshim Chowdhury. He has greatly helped us by giving us the
necessary information regarding the project that they want to invest in.
2. Secondary source: The secondary source of information contains those valuable
lectures that our respected course instructor Dr. Md. Jahangir Alam has provided us.

2

They have been greatly used during the analysis and the notes are included in Section
4.0 of the report.
1.5 Limitations
Certain limitations were faced while making the report and on the methodology used.
Being a small private limited company, Rainbow Embroidery did not provide us with its
financial statements which could have been used to strengthen our analysis on the
project.
The company does not have a working internet website from which we could have
gathered more vital information.
Presence of time constraint disallowed us to carry out full length interviews with
multiple officials of Rainbow Embroidery.


3


2.0 Company and Factory Overview
Rainbow Embroidery is currently among the industry leaders when it comes to extensive
embroideries and it uses cutting edge technology imported from Japan and China in order to
excel in quality when it comes to their products. Its factory is located in the Savar Export
Processing Zone, Dhaka which was established back in 1992. Rainbow Embroidery aims to lead
the market by providing superior quality products that offer high value addition and diversity
when compared to its rivals. The company puts a great emphasis on maintaining a customer
friendly service policy and it offers a one stop solution for business partners to provide with
garments and embroidery that excel in quality. The company has also expanded its reach into
the global arena as well.
The company was initially founded as a small factory with its sole focus in operating with the
domestic embroideries at a small scale. It grew under the care of Mr. Jashim Chowdhury, who
also happens to be one of the owners of the company. Under his guidance, the company grew
within a short span of only 10 years and started receiving orders from many countries for mass
production of garments like jerseys, t-shirts, trousers etc. Rainbow Embroidery also started
focusing on the making of logos and other intricate embroideries of official jerseys for teams
like that of FC Barcelona, Juventus FC, the Portugese National Team, Paris Saint Germain to
name a few (Source: (World Football News and Update, 2013)). At the same time they were
asked to work on official club merchandises such as the embroideries on club jerseys, caps, t
shirts, etc. The factory currently has several large units each of which specializes in different
parts of the whole production process.
The factory located is located in a green part of Savar and is an indication of the companys
commitment to protect the environment. Its modern emission treatment plant ensures that the
effluents are properly treated before being released into the environment to protect the
surrounding areas for future generations. The company keenly follows all standard
environment guidelines producing modern, power efficient and less emission generating
machineries to minimize its impact on the environment. The company regards employee

4

satisfaction to be crucial in getting the best results. It provides comfortable accommodations,
meals, medical cares, group insurance and other employee welfare facilities in order to
maintain that goal. A safe and congenial working environment also ensures that workers are
well cared for and satisfied so that eventually they provide the customers with the best possible
products.
As per its mission, Rainbow Embroidery is committed to producing world class products while
encouraging the local industries to upgrade and meet global challenges. Today, it is on par with
the best manufacturers around the world. As a world class operation, Rainbow Embroidery
remains committed to satisfying customers with unwavering quality and unbeatable service.


5


3.0 Project Overview
As Rainbow Embroidery differentiates, it needs to expand its product volume. As our country
goes on its way to become a giant in the global garment industry, it needs to tackle more orders
of making jerseys that are coming at rapid pace to our country.
Due to this increased order of jerseys throughout the country, Rainbow Embroidery is planning
to invest in three different types of machines. These machines will be used to embroider logos
on the jerseys that will then be sold to the companies abroad from which subcontracts have
originally been received. The company intends to buy a total of 30 machines (there are three
different models of these machines).
Machine Model No. of machines to be bought Per unit cost of machine
Machine 1: Baruban
(Model: BEDFH#YN/YF#BF)
15 units BDT 70 lacs
Machine 2: Paajima KM
(Model: TFKM#920)
8 units BDT 70 lacs
Machine 3: Paajima FM
(Model: TFFM#920)
7 units BDT 45 lacs
Figure: Table 1
With these machines and the vision of expansion in their mind, Rainbow Embroidery can
embroider more units of jerseys. The total life of the project is 10 years as confirmed by Mr.
Joshim Chowdhury. At the end of these 10 years, the company intends to sell these machines at
the market values during that time. The required rate of return from the project is 16%. The
lives of the machines and their market values at the end of the stated period are given in the
following page.



6


Machine
Model
Machine Life Salvage Value (at end of
the life of the machine)
Market value
After 10 years After 20 years
Machine 1 20 years BDT 45 lacs BDT 61 lacs BDT 50 lacs
Machine 2 20 years BDT 42 lacs BDT 61lacs BDT 50 lacs
Machine 3 20 years BDT 18 lacs BDT 38 lacs BDT 20 lacs
Figure: Table 2
These figures given above will be used during an analysis of the project to see whether it is
feasible and profitable or not. Along with this information, a further set of information which
will be used during the analysis of the project are given below.
Components Amounts
Selling price of embroidered jerseys (BDT per unit) BDT 24
Per unit variable cost of embroidering (BDT per unit) BDT 12
Total overhead rate (BDT per unit) BDT 15
Operating time of the machines (hours per day) 14 hours per day
Number of embroideries in an hour using each machine 40 units
Figure: Table 3



7


4.0 Capital Budgeting Methods
And Capital Investment Decisions
4.1 Capital Budgeting Methods
Net Present Value Method:
It is the present value of all cash inflows minus the initial investment.


If NPV is positive the project is accepted. If NPV negative, the project is rejected.
Profitability Index:
It is the sum of the present values of all cash inflows divided by initial investment.



If profitability index is greater than 1, the project should be accepted. If it is less than 1, the
project should be rejected.
Internal Rate of Return:
It is the rate of return from the project. It is the discount rate at which the sum of present
values of all cash inflows equals initial investment.


If IRR is greater than the required rate of return, project is accepted. If it is less than the
required rate of return, the project is rejected.

8


4.1 Capital Investment Decisions
Capital Investment Decisions:
To evaluate a project, a firm requires to estimate of related items of a project. They may be:
1. Total investment required
2. Working capital requirement
3. Quantity to be sold
4. Unit selling price
5. Unit variable cost
6. Fixed cost
Pro forma financial statements:
In evaluating a project it is required to prepare projected financial statement. This projected
financial statement is called pro forma financial statement. It is the financial statement
projecting future years operations.
Pro forma cash flow statement:
Project cash flow = Project operating cash flow Addition to capital spending Addition to net
working capital.




9


5.0 Analysis of the Project
Before making the Pro Forma Financial Statements, the calculations of the values of the
different components have been shown below.
1. Total initial investment required:
Machine No. of machines
(A)
Per unit machine cost
(B)
Total cost per model
(A B)
Machine 1 15 units BDT 7,000,000 BDT 105,000,000
Machine 2 8 units BDT 7,000,000 BDT 56,000,000
Machine 3 7 units BDT 4,500,000 BDT 31,500,000
Total initial investment required BDT 192,500,000
Figure: Table 4
The values used in this table have been gathered from Table 1 in Segment 3.0 of the report. As
we can see, the total initial investment adds up to BDT 192,500,000.
2. Total units to be sold:
Machine Units produced
per hour per
machine (C)
No. of
Machines
(D)
Units
produced per
hour (C D)
Hours
worked per
day (E)
Days per
year
(F)
Units per year
(C D E F)
Machine 1 40 units 15 600 units 14 hours 300 2,520,000
Machine 2 40 units 8 320 units 14 hours 300 1,344,000
Machine 3 40 units 7 280 units 14 hours 300 1,176,000
Total number of units sold per year 5,040,000
Figure: Table 5
The values used in this table are from Table 1 and Table 3 in Segment 3.0 of the report. We
have assumed that the number of working days in a year for the company to be 300 days

10

adjusting for the holidays and vacations of the workers. We have found out the total number of
units sold in a year to be 5,040,000 units. Mr. Joshim Chowdhury has confirmed that Rainbow
Embroidery does not keep any finished goods left in their ending inventory at the end of each
year. This means that the total number of units produced in a year is the total number of units
sold in a year.
3. Total sales per year:
As mentioned in Table 3 in Segment 3.0 of the report, per unit selling price of the finished good
is BDT 24. Thus, using this value and the value of total number of units to be sold in a year from
Table 5 in the previous page (which is 5,040,000 units), we can calculate the Total sales per
year.



Thus, from the calculation that has been showed above, the total sales per year if Rainbow
Embroidery accepts the project is BDT 1,20,960,000.
4. Total variable cost per year:
As mentioned in Table 3 in Segment 3.0 of the report, per unit variable cost (confirmed by Mr.
Joshim Chowdhury) is BDT 12. This value and the value of the total number of units to be sold in
a year from Table 5 in the previous page can be used to calculate the Total variable cost per
year.




Calculation 1:
Total sales per year = Selling price per unit Number of units sold per year
= BDT (24 5,040,000)
= BDT 1,20,960,000




Calculation 2:
Total variable cost per year = Variable cost per unit Number of units sold per year
= BDT (12 5,040,000)
= BDT 60,480,000




11

Thus, from the calculation that has been shown above, the total variable cost per year from the
project will be BDT 60,480,000.
5. Total fixed cost per year:
As mentioned in Table 3 in Segment 3.0 of the report, the overhead rate per unit of output is
BDT 15. This overhead rate per unit consists of both fixed cost and variable cost. This value
along with the value of the total number of units to be sold in a year from Table 5 and the value
of total variable cost per year from the previous page can be used to calculate the Total fixed
cost per year.










Thus, from the calculation that has been shown above, the total fixed cost per year from the
project will be BDT 15,120,000.
6. Total depreciation expense from the machines per year:
To calculate the total depreciation from the machines per year, the values that will be required
are:
Cost of per unit machine (Table 1 from Segment 3.0 of the report)
Calculation 3:
Total overhead per year = Overhead rate per unit Number of units sold per year
= BDT (15 5,040,000)
= BDT 75,600,000
Again,
Total overhead per year = Total variable cost per year + Total fixed cost per year
Or,
Total fixed cost per year = Total overhead per year - Total variable cost per year
= BDT (75,600,000 60,480,000)
= BDT 15,120,000




12

Number of machines to be bought (Table 1 from Segment 3.0 of the report)
Life of the machines (Table 2 from Segment 3.0 of the report)
Salvage value of the machines at the end of their lives (Table 2 from Segment 3.0 of the
report)
Depreciation will be calculated in the following way:





The depreciation expenses per year per machine calculated above can now be used to find the
total depreciation expense per year.
Machines Depreciation expense per
machine per year (G)
No. of machines
(H)
Depreciation expense
per year (G H)
Machine 1 BDT 125,000 15 BDT 1,875,000
Machine 2 BDT 140,000 8 BDT 1,120,000
Machine 3 BDT 135,000 7 BDT 945,000
Total depreciation expense per year BDT 3,940,000
Figure: Table 6
7. Pro forma income statement
The values that have been identified in the previous calculations and tables will now be used to
construct a pro forma income statement for Rainbow Embroidery. As there are no changes in
the annual values of sales, total variable cost, total fixed cost and depreciation expenses
throughout the years, one income statement has been shown which is constant for Years 1 to
Calculation 4:
Depreciation expense for each machine = (Cost of machine Salvage value) Life of machine
The depreciation expenses per year are:
For each unit of Machine 1 = BDT {(7,000,000 4,500,000) 20} = BDT 125,000
For each unit of Machine 2 = BDT {(7,000,000 4,200,000) 20} = BDT 140,000
For each unit of Machine 3 = BDT {(4,500,000 1,800,000) 20} = BDT 135,000







13

10 of the project. The corporate tax rate for non-publicly traded companies like Rainbow
Embroidery is 37.5% (Source: (Laila, 2012)).











A graph showing the various components in the income statement as a percentage of Sales
are given below.

Figure: Graph 1
50%
13%
3%
13%
21%
Variable Costs
Fixed Costs
Depreciation
Tax
Net Income
Rainbow Embroideries
Pro forma Income Statements (For the end of Years 1 to 10)
Years 1 to 10 (in BDT)
Sales 120,960,000
Less:
Variable Costs (60,480,000)
Fixed Costs (15,120,000)
Gross Profit 45,360,000
Less: Depreciation Expenses (3,940,000)
Earnings Before Taxes 41,420,000
Less: Tax (37.5%) (15,532,500)
Earnings After Taxes 25,887,500




14

8. Pro forma cash flow statement
To construct the pro forma cash flow statement, the first step is to calculate the Operating
Cash Flow. The operating cash flow will be constant throughout the years 1 to 10 and can be
found out using the following method.




This value of the operating cash flow per year can now be used to make the cash flow
statement. All the values in the Cash Flow statement below are in BDT.











Calculation 5:
Operating cash flow = Net Income + Depreciation expense
= BDT (25,887,500 + 3,940,000)
= BDT 29,827,500





Rainbow Embroideries
Pro forma Cash Flow Statements (For the end of Years 1 to 10)
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10
O
.
C
.
F
.

29,82
7,500
29,82
7,500
29,82
7,500
29,82
7,500
29,82
7,500
29,82
7,500
29,82
7,500
29,82
7,500
29,82
7,500
29,827,
500
C
a
p
.

S
p
e
n
d
i
n
g


(192,50
0,000)


104,31
2,500
P
r
o
j
e
c
t


C
.
F
.


(192,50
0,000)


29,82
7,500

29,82
7,500


29,82
7,500

29,82
7,500

29,82
7,500

29,82
7,500

29,82
7,500

29,82
7,500

29,82
7,500

134,14
0,000



15

The value of the Capital Spending in Year 0 is the value of the initial investment that has been
found out in Table 4 in the same segment of the report. The value of Capital Spending in Year
10 has been found out using the method shown below (for the numbers refer to Table 2 of
Segment 3.0 of the report).

















Calculation 6:
Value of Capital Spending in Year 10 = Market value of all the machines Tax on it
For 15 units of Machine 1, Total market value = 15 BDT 6,100,000 = BDT 91,500,000
For 8 units of Machine 2, Total market value = 8 BDT 6,100,000 = BDT 48,800,000
For 7 units of Machine 3, Total market value = 7 BDT 3,800,000 = BDT 26,600,000
Total Market value of all the machine = BDT 91,500,000 + BDT 48,800,000 + BDT 26,600,000
= BDT 166,900,000
Tax on market value of all the machines = 0.375 BDT 166,900,000
= BDT 62,587,500
Value of Capital Spending in Year 10 = BDT (166,900,000 62,587,500)
= BDT 104,312,500


16

9. Calculation of Net Present Value
Using the values of the Project Cash Flow from Years 1 to 10 shown in the Pro forma cash
flow statement, we will calculate the Net Present Value of the project. As mentioned in
Segment 3.0 of the report, the required rate of return from the project is 16%. The calculation
has been shown below.












As we can see from the calculation above, the value of NPV for the project at a return of 16% is
BDT 24,690,974. Because the Net Present Value is negative, the project should not be
accepted.




Calculation 7:
= PV of Yr 0 + PV of Yr 1 + PV of Yr 2+ PV of Yr 3 + PV of Yr 4 + PV of Yr 5
+ PV of Yr 6 + PV of Yr 7 + PV of Yr 8 + PV of Yr 9 + PV of Yr 10
=



= BDT ( 192,500,000 + 25,713,362.1 + 22,166,691.4 + 19,109,216.8 + 16,473,462.8
+ 14,201,261 + 12,242,466.4 + 10,553,850.3 + 9,098,146.8 + 7,843,230
+ 30,407,338.6)
= BDT 24,690,974






17

10. Calculation of Profitability Index
Using the values of the Project Cash Flow from Years 1 to 10, we will calculate the Profitability
Index of the project. The calculation has been shown below.












The value of the Profitability Index of the project is 0.8717. As it is less than 1, the project
should not be accepted.



Calculation 8:
= (PV of Yr 1 + PV of Yr 2+ PV of Yr 3 + PV of Yr 4 + PV of Yr 5 + PV of Yr 6 + PV of Yr 7
+ PV of Yr 8 + PV of Yr 9 + PV of Yr 10) PV of Yr 0
=



= (25,713,362.1 + 22,166,691.4 + 19,109,216.8 + 16,473,462.8 + 14,201,261 + 12,242,466.4
+ 10,553,850.3 + 9,098,146.8 + 7,843,230 + 30,407,338.6) 192,500,000
= 0.8717





18

11. Calculation of Internal Rate of Return
Using the values of the Project Cash Flow from Years 1 to 10, we will calculate the Internal
Rate of Return of the project. The calculation has been shown below.



Calculation 9:
At a discount rate of 13%,
PV of cash flows from Yr 1 to 10 = PV of Yr 1 + PV of Yr 2 + PV of Yr3 + PV of Yr 4
+ PV of Yr 5 + PV of Yr 6 + PV of Yr 7 + PV of Yr 8
+ PV of Yr 9 + PV of Yr 10
=



= BDT 192,580,524.3
At a discount rate of 14%,
PV of cash flows from Yr 1 to 10 = PV of Yr 1 + PV of Yr 2 + PV of Yr3 + PV of Yr 4
+ PV of Yr 5 + PV of Yr 6 + PV of Yr 7 + PV of Yr 8
+ PV of Yr 9 + PV of Yr 10
=



= BDT 183,721,340.6






19

From the calculation shown overleaf, we see that for the present values of cash flows from year
1 to year 10 are:
BDT 183,721,340.6 for a 14% discount rate
BDT 192,580,524.3 for a 13% discount rate
The initial investment on the whole project was BDT 192,500,000 and we see that this value of
the initial investment lies between the sum of present values at discount rates of 13% and 14%.
This means that the internal rate of return is between these two discount rates.
The internal rate of return for the project is determined below.









As the calculated IRR for the project (which is 13.0091%) is lower than the required rate of
return of 16%, the project should not be accepted.
Calculation 10:
For a change in the PV of BDT (192,580,524.3 183,721,340.6), there is a change in 1%
discount rate
Thus, for a change in PV of BDT (192,580,524.3 192,500,000), the change in discount rate is:
= (192,580,524.3 192,500,000) (192,580,524.3 183,721,340.6)
= 0.0091%
Therefore, IRR = 13% + 0.0091%
= 13.0091%


20


6.0 Recommendation
The findings from the analysis section of the report are repeated once again:
The Net Present Value is negative.
The Profitability Index is less than 1.
The Internal Rate of Return is less than the required rate of return.
All these findings compel us to recommend that Rainbow Embroidery should not accept this
project.


21


7.0 Bibliography

Laila, U. (2012, July). Tax Rates in Bangladesh. Retrieved June 18, 2013, from Blogspot:
http://taxratesinbangladesh.blogspot.com/
World Football News and Update. (2013, June 18). World Football News and Update. Retrieved
from Worldwide Football:
https://www.facebook.com/worldwide.football/posts/529842653746630

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