Capital Budgeting: The Ultimate Guide

In making investment decisions, capital budgeting is a part of investment analysis which help the company to determine the capital required to achieve a predetermined level of strategic growth (Götze, Northcott, & Schuster, 2015) . The process of capital budgeting involves the determination of underlying costs of budgeting as well as the expected income from the project or investment in order to determine the profit which would be obtained from the capital expenditure. After the margin is determined, the best sources of capital are determined in order to assess the most effective way to finance the project (Götze, Northcott, & Schuster, 2015) . This helps a company determine the point at which the capital investment will break even as well as the viability of the capital investment. The first part of the analysis shall be a risk analysis to evaluate the economic environment risk which the company may face. The paper will then analyze the company’s application and uses of funds as outlined in the cash flow statement of the company. Thereafter shall be a product costing analysis to determine the price at which the company will break even on the new product. The paper shall then determine and evaluate the different sources of funds available to the company in order to determine the best financing activity which the company can engage in in order to finance the capital investment. The paper will then conclude by giving an overview of the analysis with focus on the risk factors of the investment, the responsibility of the management accountant and financial controller, and also the recommendations on the direction which the company would need to undertake with regards to the investment. The purpose of this paper is to conduct capital budgeting for ABC company which wishes to expand its product portfolio. It is hoped that, from the capital budgeting analysis, it shall be determined the best plausible step of action that the company shall take regarding expansion of the company’s product portfolio.

Risk Profile 

The company faces various environmental risks on account of its market position as well as the industry in which it operates. The first risk is the current economic conditions of the United States. The instability of the US currency, occasioned by the luck of sufficient investor confidence in the policies of the current government administration has reduced the value of the country’s currency. This therefore means that investors are opting to invest in more stable economies and faster growing economies. The effect of instability of the currency is that interest rates become volatile and therefore investors tend to move away from investing in the country. This follows the growing concern over investment in fixed assets and real estate following public reservations on account of the effects of over investment in the wake of the 2008/2009 financial crisis. In this way, the company would have to find roofing materials that are cheaper to produce in order to reduce the price of roofing materials. In this way, investors will be more willing to invest in the materials of the company and thus increase their profit margin.

The second risk that the company faces is industry competition. The building materials industry has little barriers of new entry into the industry. This means that the level of competition increases significantly due to the fact that more players in the industry compete for the dwindling number of potential customers. The effect of competition is the reduced market share which reduces revenues and the reduced prices of the company’s products which reduces the sales revenue of the company. Additionally, the competition in the industry increases investor risks and thereby increasing the price of capital. The price of capital increases the cost of investing and therefore it becomes expensive for organizations in the particular industry to find reasonably priced capital. This increases the prices of the products which in turn reduces customer attraction and hence reducing the profit margins of the organization.

Cash-Flow Statement Analysis 

The company’s cash flow statement indicates a high level of investing activity. The major spending of the company is in investing activities. The company uses its investments to fund dividends which are an indication of lack of proper budgeting. However, the company has strategized this method in order to attract investors with high dividend payout (Götze, Northcott, & Schuster, 2015) . While this method is effective, the response of the investors would greatly affect the company’s operations if there is negative response from the shareholders. Additionally, the company operates at a negative networking cash flow. This reduces the liquidity of the company and there would be cash flow issues with immediate debts. The company should look into ways of operating under positive networking capital in order to avoid spending the company’s capital to offset debts. One of the ways this can be improved is reducing the average debtor payment period in order to match the creditor days. This will help the company maintain healthy liquidity levels.

The current cash flow position cannot be used to finance the project. This is because the capital budget of the project is higher than the cash balance of the company. This will mean that the company shall be required to raise finance from a different source. Additionally, the company’s investments are already at a high level as compared to the incomes of the company and this therefore means that the company is currently using its retained earnings to offset its liabilities (Götze, Northcott, & Schuster, 2015) . Capital projects require external funding in order to cushion the company from the adverse effects of low capital returns. The company should source for funds from other sources in order to protect its liquidity as well as to ensure that the cost of financing the project does not negatively affect its cash flows. Capital projects normally take longer periods of time to mature and to break even. This means that the sources of finance used to finance the project should be equally long term in order to maintain the liquidity requirements of the company. Therefore, the current liquidity position limits the availability of internal sources of funds.

In order to finance the project, the company should look into corporate debt as a source of finance. The cost of debt normally comes under three categories, the perpetuity of the debt, the cost of control, and the cost of the debt (Götze, Northcott, & Schuster, 2015) . While equity is often cheaper than corporate debt, the implication of the debt is such that, the debt cannot be fully repaid due to the fact that the investors become shareholders of the company. Additionally, the company loses some of the control in the investment as equity debt accrues control costs. On the other hand, corporate debt can be repaid in full from the income accruing from the investment. The certainty of the date of repayment makes it easier to ascertain breakeven points as the breakeven points shall be at the point where the investment can match its cost of capital (Götze, Northcott, & Schuster, 2015) . Moreover, corporate debt does not have an attached control cost as the investor is only interested in the income from the investment and not the application of the investment. Therefore, it shall be more financially viable if the investment was funded from corporate debt.

Product Costing 

Product costing is the process of allocating costs of the company to an item manufactured in order to ascertain the cost of producing a single product (Stark, 2015) . This is necessary in companies as it helps to determine the price of the commodity. In this way, the company can avoid losses by producing a product which would have small margins or whose prices, as determined by the cost of the product will not be accepted by the consumer. The purpose of this is to ascertain which products the company can focus on and which products the company can do away with (Stark, 2015) . In this section, the cost of the intended product shall be determined. In product costing, there are a number of ways in which the costs are allocated to the product. For the purposes of this particular analysis, the paper applies the direct and indirect costs methods in determining the cost of the product. The direct costs are the machine hours used to produce the product. The indirect costs refer to the factory overheads which cannot be particularly identified to a particular product unit and they are therefore allocated with regards to a standard unit measure, which in this case are the fixed sales expenses.

Under absorption costing, the cost of a product comprises of all production costs regardless of whether they are variable or fixed (Stark, 2015) . In this case, the cost of the product will comprise of; machine hours, direct materials, direct labor, variable factory overheads, and variable selling expenses. Therefore, under this method, the cost of the expansion product shall be the total of all costs with the total fixed overheads being divided into the number of units regardless of their weights which is equal to $ 10.18 per product. Under the variable costing method, the variable costs are assigned to the individual products while the fixed costs are only added in the determination of the profit of the organization (Stark, 2015) . Therefore, the cost of the products shall only include the variable cost of the products which is equal to $ 5.60.

Due to the fact that under absorption costing the fixed costs are allocated to the number of products, the increase in the number of products reduces the cost per product. The fixed overheads total to $ 389,250.00. Before the introduction of the expansion product, this cost was divided among Eighty thousand units of the current product and therefore the fixed overhead cost per unit was $ 4.87. However, when the new product is introduced, the number of products to be divided by the total fixed overhead costs increases to Eighty Five thousand units. This means that the unit fixed overhead cost reduced to $ 4.58. Therefore, the total reduction in unit cost of the current product attributed to the introduction of the expansion product is the difference between the previous cost of $ 4.87 and the expanded cost of $ 4.58 which is equal to $ 0.29.

Selling prices are a derivative of the cost of the product and the gross profit margin (Stark, 2015) . From the previous calculations, it was ascertained, under absorption costing that the cost of producing a unit of the expansion product is $ 10.18. The gross profit of the unit product is obtained by multiplying the expected gross profit margin of Forty percent by the cost of the product. The resultant figure of $ 4.10 shall be the gross profit for a unit of the expansion product. Adding the gross profit to the cost, $ 14.28 is obtained as the selling price of the expansion product.

Potential Investments to Accelerate Profit 

Net present value of an investment is defined as the value of the future cash inflows of an investment stated in current monetary terms (Götze, Northcott, & Schuster, 2015) . This method of valuing investments is applied in order to ascertain the viability of the project in meeting its long term financing obligations in terms of interest and principle repayment. The net present value is calculated by adding the discounted cash flows of the investment. The discounted cash flow is obtained by multiplying the cash inflow by the product of the required rate of return and the number of years under consideration. The net present value of the project is (negative) $ 1,366.08.

The impact of depreciation when absorbed into the costs of the product is that they inflate the product (Götze, Northcott, & Schuster, 2015) . In this case, the annual depreciation of the machine shall be $ 8,400.00. This means that the fixed costs of the factory shall be increased by the amount of annual depreciation. The cash inflow will not however be affected by the depreciation due to the fact that depreciation is a non-cash expense and does not affect depreciation.

While purchase of the equipment shall have no impact on the cash flows of the company, it would be prudent for the company to purchase it as the machine will increase revenues while minimizing cash outflow. However, the machines net present values are negative due to the low returns which it offers and should therefore not be purchased.

Conclusion 

The major risk factor which has been noted to arise from this project is the productivity of the required equipment. The incremental revenue from the expansion product is not sufficient to support the investment into the expansion product. The role of the financial controller is to ensure that the finance of the organization are obtained at the lowest cost and the application of the sourced finance is on the projects and investments with the highest returns. The role of the cost manager is to ensure that the products of the organization are reasonably priced in such a way that the costs of the organization are absorbed by consumer. It is recommended that the CEO should not invest in the new expansion product.

References 

Götze, U., Northcott, D., & Schuster, P. (2015). Capital Budgeting and Investment Decisions. In Investment Appraisal (pp. 3-26). Springer Berlin Heidelberg.

Stark, J. (2015). Product lifecycle management. In Product Lifecycle Management (pp. 1-29). Springer International Publishing.