Question

nded fabric. Assume or of capital budgeting, and costs, as to why the NI firm's required rate of return is constant al Somu Integrative Problem 13-35 Argile Textiles is evaluating a new product, a silk/wool blended fabric. A that you were recently hired as assistant to the director of capital budgetin you must evaluate the proposed project. The fabric would be produced in an unused building located adjacent to Argile's Southern Pines, North Carolina, plant; Argile owns the building, which is fully depreciated. The required equipment would cost $200,000 plus an additional $40,000 for shipping and installation. With the new pro inventories would rise by $25,000, and accounts payable would increase bu $5,000. All of these costs would be incurred at t = 0. By a special ruling, the machinery could be depreciated under the MACRS system as 3-year property (see Appendix 13A). The project is expected to operate for four years, and then be terminated. The cash inflows are assumed to begin one year after the project is undertaken. or at t = 1, and to continue to t= 4. At the end of the project's life (t = 4), the equipment is expected to have a salvage value of $25,000. Unit sales are expected to total 100,000 five-yard rolls per year, and the expected sales price is $2 per roll. Cash operating costs for the project (total operating costs excluding depreciation) are expected to amount to 60 percent of dollar sales. Argile's marginal tax rate is 40 percent, and its required rate of return is 10 percent. Tentatively, the silk/wool blend fabric project is assumed to be of equal risk to Argile's other assets. You have been asked to evaluate this project and to make an accept/reject recommendation. To guide you in your analysis, your boss has asked you to answer the following set of questions.

Please Answer A-D

Answer 1

Q.a What is Capital Budgeting :

Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. For example, Construction of a new plant or a big investment in an outside venture that would require capital budgeting before they are approved or rejected.

As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows to determine whether the potential returns that would be generated meet a sufficient target benchmark. The process is also known as investment appraisal.

Ideally business would pursue any and all projects and opportunities that enhance shareholder value. However, because the availability of capital in any business for new projects is limited, management uses capital budgeting techniques to determine which projects will yield the best return over an applicable period.

Some methods of capital budgeting companies use to determine which projects to pursue include :

i) Throughput Analysis,

ii) Net Present Value (NPV),

iii) Internal Rate of Return,

iv) Discounted Cash Flow, and

v) Payback Period.

Some key points to remembered in relation to Capital Budgeting :

• Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment.
• The process involves analysing a project’s cash inflows and outflows to determine whether the expected return meets a set benchmark.  
• The major methods of capital budgeting include throughput, discounted cash flow, and payback analyses

Are there any similarities between a firm's Capital Budgeting decisions and an Individual's investment decisions :

Capital Budgeting process of a firm is relatively similar or identical to the process of making Individual's investment decisions. Below are some common septs used by both the processes for evaluating investment decisions (by the Firm for capital budgeting as well as by the Individual for investment) :

1. Estimation of the Cash Flows - Initial Cash Outflow and subsequent Cash Inflows for the period of investment / project.

2. Assessment of the Risk Associated with Cash Flows

3. Determination of the discount rate based on the riskiness of the cash flows as well as interest rates. This process is called the projected cost of capital.

4. Find the Present Value (PV) of the expected cash flows and / or the asset rate of return.

5. If the PV of Inflow is greater than the PV of Outflow (meaning if the NPV is greater than zero), or if the IRR (Internal Rate of Return) is higher than the project's cost of capital, the project or the investment is accepted, else it is rejected.

Q.b What is the difference between independent and mutually exclusive projects?

Independent Projects : Projects are independent if the cash flows of one project are not affected by the acceptance of the other projects. Depending on the availability of Capital, a firm can accept all such projects which meets the benchmark set by the firm in terms of NPV, IRR etc.  

Mutually Exclusive Projects : Two or more projects are mutually exclusive if acceptance of one affects adversely the acceptance of the other projects. That is, at most one of two or more such projects can be accepted. In such case, project which yields the highest return in terms of benchmark set by the Firm is accepted to maximise the wealth of the firm.

Difference between Projects with Conventional Cash Flows and Projects with Non-conventional Cash Flows :

Projects with Conventional Cash Flows :

A project or investment with a conventional cash flow starts with a negative cash flow (the investment period), followed by successive periods of positive cash flows generated by the project once completed. The rate of return from the investment or project is called the internal rate of return (IRR).

Projects with Non-conventional Cash Flow :

Projects or investments with Non-conventional cash flows involve more than one change in cash flow direction and result in two rates of returns at different intervals. In other words, non-conventional cash flows have more than one cash outlay or investment, while conventional cash flows only have one.

A few key points to remember :

• Conventional cash flow means that a project or investment has an initial cash outlay followed by a series of positive cash flows generated from the project.
• Projects with Conventional cash flows have only one internal rate of return (IRR), which should exceed the hurdle rate or minimum rate of return needed.
• Conversely, Projects with Non-conventional cash flows have multiple outlays of cash over a project's life and as a result, multiple IRRs.
• Non-conventional cash flow is more difficult to handle in NPV analysis than conventional cash flow since it will produce multiple internal rates of return (IRR), depending on the number of changes in the cash flow direction.

In real-life situations, examples of unconventional cash flows are abundant, especially in large projects where periodic maintenance may involve huge outlays of capital. For example, a large thermal power generation project where cash flows are being projected over a 25-year period may have cash outflows for the first three years during the construction phase, inflows from years four to 15, an outflow in year 16 for scheduled maintenance, followed by inflows until year 25.

Difference between Replacement Analysis and Expansion Analysis :

Replacement Analysis / Projects: these are projects where the firm must either: replace worn out equipment or invest in new equipment that is expected to lower current production costs and/or increase current sales.

Expansion Analysis / Projects: these are projects where the firm seeks to profitably increase sales of current products or introduce new products into the market.

Few Key Points on Replacement Analysis & Expansion Analysis :

a) Replacement Analysis : The replacement of assets offer economic opportunity for the firm. In replacement analysis there is two alternatives:

• The assets that are currently using : The defender
• The assets that we have to buy to replace current assets : The challenger

Factors considered in Replacement Analysis :

• Sunk costs to be ignored
• Existing asset value need not be considered
• Income tax to be avoided
• The optimal replacement cycle is one which has lowest equivalent annual cost
• The replacement decision will apply indefinitely.
• Economic life of the challenger and the defender should not consider

b) Expansion Analysis :

Expansion is the phase of the business cycle where real GDP grows for two or more consecutive quarters, moving from a trough to a peak. This is typically accompanied by a rise in employment, consumer confidence, and equity markets. Expansion is also referred to as an economic recovery.

Key Points :

• Expansion is the phase of the business cycle when the economy moves from a trough to a peak.
• Expansions last on average about four to five years but have been known to go on anywhere from 12 months to more than 10 years.
• Focusing on interest rates and capital expenditure can help investors to determine where we are in the business cycle.

Q.c Cash Flow Time Line :

            A cash flow timeline is a horizontal line with up-arrows that represent cash inflows (that is, cash to be received by the decision maker) and down-arrows to indicate cash expenses or outflows. The down arrow at Time 0 represents an investment today; the up-arrow n periods in the future represents $FV, the future value (or compounded value) of the investment.

Q.d Argile's  Silk / Wool Blend Project ( $ thousands)

End of Year	0	1	2	3	4
Unit Sales (thousands)	0.00	100	100	100	100
Price Per Unit	0.00	$2.00	$2.00	$2.00	$2.00
Total Revenues	0.00	$200.0	$200.0	$200.0	$200.0
Costs Excluding Depreciation	0.00	($120.0)	($120.0)	($120.0)	($120.0)
Depreciation	0.00	($79.2)	($108.0)	($36.0)	($16.8)
Total Operating Cost	0.00	($199.2)	($228.0)	($156)	($136.8)
Earning before Taxes (EBT)	0.00	$0.80	($28.0)	$44	$63.2
Taxes (40%)	0.00	$0.32	0.00	$17.6	$25.28
Net Income	0.00	$0.48	($28.0)	$26.4	$37.92
Depreciation	0.00	$79.2	$108.0	$36.0	$16.8
Supplemental Operating Cash Flow	0.00	$79.68	$80.0	$62.4	$54.72
Equipment Cost	$200.0
Installation Cost	$40.0
Increase in Inventory	$25.0
Increase in Accounts Payable	($5.0)
Salvage Value					$25.0
Tax on Salvage Value					($10.0)
Return of Net Working Capital					$20.0
Cash Flow Time Line (Net Cash Flows)	($260.0)	$79.68	$80.0	$62.4	$89.72