| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Initial Outlay | $50,000 | |||||
| Revenue | $63,000 | $65,000 | $67,000 | $69,000 | $71,000 | |
| Less: operating expenses | ($14,000) | ($15,000) | ($16,000) | ($17,000) | ($18,000) | |
| Less: Consulting fees and expenses | ($525 ) | ($550) | ($575) | ($600) | ($625) | |
| Earnings before depreciation and tax | $48,475 | $49,450 | $50,425 | $51,400 | $52,375 | |
| Less: depreciation | $43,750 | $43,750 | $43,750 | $43,750 | $43,750 | |
| Earnings before tax | $4,725 | $5,700 | $6,675 | $7,650 | $8,625 | |
| Less: 40% tax | $1,890.0 | $2,280.0 | $2,670.0 | $3,060.0 | $3,450.0 | |
| Earnings After tax | $2,835.0 | $3,420.0 | $4,005.0 | $4,590.0 | $5,175.0 | |
| Add back depreciation | $43,750 | $43,750 | $43,750 | $43,750 | $43,750 | |
| Annual cash flow | $46,585.0 | $47,170.0 | $47,755.0 | $48,340.0 | $48,925.0 | |
| NPV | ($50,000) | -$3,415 | -$2,830 | -$2,245 | -$1,660 | -$1,075 |
Total cash flow = $238,755
Less: Initial investment (50,000)
NPV = $238,755 - $50,000 = $188,775
Capital budgeting decisions are used in the planning process of the company. The different decisions and appraisal processes helps to plan for long term investment such as to determine whether the company can replace new equipment or use additional financing. Some of the different methods of capital budgeting used include Net Present Value, Accounting rate of return, Profitability index, Payback period, and Internal rate of return among others (Williams, et al. 2008)
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Net Present Value
My first analysis to determine whether Pizza Planet Co. should install the new equipment will be the NPV evaluation. The annual cash flow is for the next five years, where the company’s revenue has been increasing with a margin of $2,000. The company must first come up with the present value cash flows for the period. The expenses will reduce the revenue earned to come up with Earnings before tax. After tax value is evaluated after subtracting 40% tax from the earnings before tax. The NPV is estimated by subtracting the investment cost from the annual cash flow. The NPV value is positive at $188,775 after the five year investment. The value of NPV proves that the company can install the new equipment and make more profit.
Profitability Index
The profitability index is used as an appraisal process which is estimated by dividing the present value of cash flows by the initial investment cost of the project.
PI = $238,755/ $50,000 = 4.78
The decision rule that companies make is to accept a project if the Profitability index value is greater than one and reject the project if the PI is below 1. The PI index is also related to the benefit cost ratio and it helps in ranking projects as per the return expected. With a PI of 4.78, Pizza Planet Co. can install the new equipment at minimal cost.
Payback Period
Another decision rule can be estimated using the payback period calculation. The period is estimated as the time the company will recoup the funds expected in an investment (Groppelli & Ehsan, 2000). The initial step is to estimate the cumulative cash flows for the five years.
| year | Cash flow | Cumulative cash flow |
| 1 | $46,585.0 | $46,585 |
| 2 | $47,170.0 | $93,755 |
| 3 | $47,755.0 | $141,510 |
| 4 | $48,340.0 | $189,850 |
| 5 | $48,925.0 | $238,755 |
The payment period will be between the first and the second year. To estimate the actual period of repayment,
1year + ($50,000/$93,755) = 1.052
The decision rule is that when the project takes little repayment period it is worth the investment. When the payback period takes long the company should reject the new project. Pizza Planet Co should install the project since it will take little time for the initial cash outflow of the investment to be recovered from the cash inflows generated.
From the three capital decisions estimated for the company, Pizza Planet Co should install the new equipment.
References
Groppelli, A. A. & Ehsan N. (2000). Finance, 4th ed. Barron's Educational Series, Inc. p. 433
Houston, J. F. & Brigham, E. F. (2009). Fundamentals of Financial Management. [Cincinnati, Ohio]: South-Western College Pub. p. 90
Williams, J. R.; Susan F. H. ; Mark S. B & Joseph V. C. (2008). Financial & Managerial Accounting. McGraw-Hill Irwin
