Capital Budgeting: How to Make Smart Investment Decisions

A quaint but well-established coffee shop, the Hot New Cafe, wants to build a new cafe for increased capacity. Expected sales are $800,000 for the first 5 years. Direct costs including labor and materials will be 50% of sales. Indirect costs are estimated at $100,000 a year. The cost of the building for the new cafe will be a total of $750,000, which will be depreciated straight line over the next 5 years. The firm's marginal tax rate is 37%, and its cost of capital is 12%. 

Using the information in the assignment description: 

Prepare a capital budget for the Hot New Cafe with the net cash flows for this project over a 5-year period. 

Capital Budget 

Capital income	Amount in $
Expected sales	800,000
Capital expenses	Amount in $
New café	750,000
Cost of capital 12% of 750,000	90,000
Total	840,000

Net cash flow 

Duration in years	Expected sales cash flow	Direct labour and materials	Indirect cost	Net Cash flow
1	160,000	80,000	20,000	60,000
2	160,000	80,000	20,000	60,000
3	160,000	80,000	20,000	60,000
4	160,000	80,000	20,000	60,000
5	160,000	80,000	20,000	60,000
Total	800,000	400,000	100,000	300,,000

Calculate the payback period (P/B) and the net present value (NPV) for the project. 

PB = Initial Investment Cash/ Inflow per Period 

Initial payment = 750,000+90,000=840,000 

Inflow per period =160,000 

Payback period = 840,000/160,000= 5.25 years 

Thus, for the project to pay back, it will take five and quarter years. 

Net Present Value 

Duration in years	Revenues	Direct labour costs	Indirect cost	Marginal tax 37%	Net present value
1	160,000	80,000	20,000	59,200	800
2	160,000	80,000	20,000	59,200	800
3	160,000	80,000	20,000	59,200	800
4	160,000	80,000	20,000	59,200	800
5	160,000	80,000	20,000	59,200	800
Total	800,000	400,000	100,000	296,000	4,000

Answer the following questions based on your P/B and NPV calculations: 

Do you think the project should be accepted? Why? 

I think the project should be accepted. This is because we have the current value which is positive thus making the whole project to be accepted. It is also essential to know the recovery of the initial outlay of the project and in this case it is 5 years. This is another aspect which makes the project to be accepted. From the above calculations, $4000 can be yielded after the project has paid back the actual value. Furthermore, the expected value is higher compared to the project installation hence by that the project is viable. 

Do you think the project should be accepted? Why? 

In my own understanding and from the calculations, this project should be accepted. This is because the payback time which was expected is within the specified is within the range of the managers. It is also true that the managers have a positive result from the calculations of the payback period and cash flow of the project. The positive results in return will generate more revenues thus making the project to generate its outlay. 

Define and describe Net Present Value (NPV) as it pertains to the new cafe . 

In accounting and finance, Net present value (NPV) can be defined as the measurement whereby the present value (PV) of the cash outflow (including initial cost) is subtracted from the value which is present of the cash inflows in order to get a profit in a designated period of time (Shrieves, & Wachowicz, 2001) . There are also other factors namely inflation and the depreciation rate which are supposed to be included in the project in order to give the future value. This inclusion of the factors will thus give the expected net present value (Shrieves, & Wachowicz, 2001) . 

Define payback period. Assume the company has a P/B (payback) policy of not accepting projects with a life of over three years. Do you think the project should be accepted? Why? 

In accounting finance, payback time can be defined as the cost of an investment or project whereby a required length of time is supposed to be recovered. It is important to note that in any investment or project, the payback period is very much essential because it determines whether to undertake the position or project (Ryan, & Ryan, 2002) . In this project it is justifiable that the business cannot make the initial outlay by the end of three years. This is because as per the café policy, it is impossible. Contrary to that, it is agreeable that the project has the capability of generating $480,000 at the end of year three. This can be justified from the calculations whereby the outlay is $750,000 hence making it impossible. 

References 

Shrieves, R. E., & Wachowicz Jr, J. M. (2001). FREE CASH FLOW (FCF), ECONOMIC VALUE ADDED (EVA™) AND NET PRESENT VALUE (NPV): A RECONCILIATION OF VARIATIONS OF DISCOUNTED-CASH-FLOW (DCF) VALUATION.    The engineering economist ,    46 (1), 33-52. 

Ryan, P. A., & Ryan, G. P. (2002). Capital budgeting practices of the Fortune 1000: how have things changed?    Journal of business and Management ,    8 (4), 355. 

Chen, G. G., Weikart, L. A., & Williams, D. W. (2014).  Budget tools: Financial methods in the public sector . CQ Press. Retrieved from: https://books.google.co.ke/books?hl=en&lr=&id=YC6LBQAAQBAJ&oi=fnd&pg=PT24&dq=Capital+budget+calculations&ots=QkUNFiWdp5&sig=bD5i9So7uf8JrrbyJqkAeETvZDo&redir_esc=y#v=onepage&q=Capital%20budget%20calculations&f=false 

Grob, H. L. (2013).  Capital budgeting with financial plans: an introduction . Springer-Verlag. Retrieved from : https://books.google.co.ke/books?hl=en&lr=&id=z6O1BgAAQBAJ&oi=fnd&pg=PA1&dq=Capital+budget+calculations&ots=FN8-P_w1lE&sig=_C-rvMxIuPKKfxoldFikXHGM1x4&redir_esc=y#v=onepage&q&f=false 

Stiglitz, J. E., & Rosengard, J. K. (2015).  Economics of the Public Sector: Fourth International Student Edition . WW Norton & Company. Retrieved from : https://books.google.co.ke/books?hl=en&lr=&id=miPeCgAAQBAJ&oi=fnd&pg=PR24&dq=Capital+budget+calculations&ots=VS3IPXj2aA&sig=y0KHbpOupdWpsHCemtLbURjRM_o&redir_esc=y#v=onepage&q&f=false