Shelton Mills Plc. Investment Project

In a business, investing activities are very common. These activities do not just happen without the management taking into account the feasibility of the project. The feasibility of a project refers to its viability economically, legally, and technicality. Economic feasibility involves determining the profitability of a project to the investor. An investor requires returns from the project hence the cash inflow and outflow have to make sense. The period for which this project starts bringing in returns is also very important. Capital budgeting techniques are some of the ways that a company can determine the financial feasibility of a project. In this essay, we analyze the financial feasibility of Shelton’s potential project using these techniques.

Investment Project Analysis

Capital budgeting techniques evaluate the viability of long-term investments to ensure that investors invest their limited resources in the most suitable projects. These techniques include the accounting rate of return (ARR), payback period, net present value (NPV), and internal rate of return (IRR). 

Accounting Rate of Return

ARR evaluates the expected profit or returns from an investment. This technique compares the average net income of a project with its investment cost. The formula is average net income less annual depreciation divided by investment cost. Shelton’s project is expected to generate the below net income in the next five years:

	Year 1	Year 2	Year 3	Year 4	Year 5
	€ '000s	€ '000s	€ '000s	€ '000s	€ '000s
Sales	450	470	470	470	470
Costs
Materials	(126)	(132)	(132)	(132)	(132)
Labor	(90)	(94)	(94)	(94)	(94)
Overheads	(45)	(47)	(47)	(47)	(47)
Depreciation	(90)	(90)	(90)	(90)	(90)
Working Capital	(180)
Development Costs	(90)
Bank interest on working capital	(27)	(27)	(27)	(27)	(27)
EBIT	(198)	80	80	80	80
Add back Depreciation	90	90	90	90	90
Add back Interest	27	27	27	27	27
Net Operating Income	(81)	197	197	197	197

The ARR for this project is the average net operating income less the depreciation of €90,000 divided by investment cost of €500,000. The ARR is shown in the table below;

Cash Flow		(81,000)		197,000	197,000	197,000	197,000
Initial Investment		500,000
Annual Depreciation	90,000
ARR	10.28%

The profitability of the project is 10.28%. Comparing this to the 12% cost of capital, the project is not feasible.

Payback Period

Payback period is a capital budgeting technique that determines the time, in year or months, that a proposed project will take to bring in returns. In Shelton’s project, the payback period is: 

Payback Period
Cash Flow	(500,000)	(81,000)	197,000	197,000	197,000	197,000
Cumulative		(581,000)	(384,000)	(187,000)	10,000	207,000
Payback Period	3 years

According to the calculations, Shelton will get returns from the project in the fourth year. In years 1-3, the investment cost has not been recovered hence the outflow. 

Net Present Value

The net present value (NPV) is a capital budgeting technique that evaluates the difference between the present value of cash inflows and outflows over a certain period. In this project, the NPV evaluates the difference between the investment cost and the cash inflows over five years. According to the calculations, the NPV is negative meaning that in the five years, the company will not receive any returns from the project. 

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cash Flow	(500,000)	(81,000)	197,000	197,000	197,000	197,000
NPV	($33,994.08)

Internal Rate of Return

IRR determines the profitability of a project to determine its feasibility. The IRR is a discount rate that makes the net present value of all cash flows within a particular period equal to zero. Shelton’s project has an IRR of 9.65%.

Cash Flow	(500,000)	(81,000)	197,000	197,000	197,000	197,000
IRR	9.65%

Memo to the Board

TO: The Board

FROM: Project Management Department

DATE: 26th November 2017

SUBJECT: Recommendation following The Investment Analysis 

Shelton Mills Plc is looking to invest in a new project. The feasibility of the project is unknown but the financial projections are as follows;

	Year 1	Year 2	Year 3	Year 4	Year 5
	in '000	in '001	in '002	in '003	in '004
Sales	450	470	470	470	470
Costs
Materials	(126)	(132)	(132)	(132)	(132)
Labor	(90)	(94)	(94)	(94)	(94)
Overheads	(45)	(47)	(47)	(47)	(47)
Depreciation	(90)	(90)	(90)	(90)	(90)
Working Capital	(180)
Development Costs	(90)
Bank interest on working capital	(27)	(27)	(27)	(27)	(27)
EBIT	(198)	80	80	80	80
Add back Depreciation	90	90	90	90	90
Add back Interest	27	27	27	27	27
EBITDA	(81)	197	197	197	197
Cash Flow	(81,000)	197,000	197,000	197,000	197,000

Based on the above financial projections, the expected cash flows from the project are € (81,000) for year one, and a constant of €197,000 for year two to five. Based on these cash flows, we calculated the feasibility of the project using capital budgeting techniques – accounting rate of return (ARR), payback period, net present value (NPV), and internal rate of return (IRR).

The ARR calculations show that the profitability of the project is 10.28%. According to the projections, Shelton expects a 12% rate of return hence a return of 10.28% is low. The ARR shows the project is not feasible and therefore, should not be accepted. On the other hand, the payback period of the project is 3 years, that is, the company should expect cash inflow from the fourth year. The payback period is too long making it hard to accept the project.

The NPV of the project is -€33,994.08. A negative NPV shows that the cash outflows are more than the cash inflows for the five years. This is to say that Shelton will not receive any returns from the project within the five years. The IRR calculations give a 9.65% rate of return which is lower than the expected rate of return of 12%. The IRR shows that the project is not feasible.

According to all the capital budgeting techniques, the proposed Shelton project is not financially feasible. The ARR (10.28%) and IRR (9.65%) rates of return are below the expected rate of return of 12%. The payback period is also too long while the NPV is negative meaning no returns for the five years. Based on this analysis, the company should not accept the project. 

However, it is important for the management to consider the organizational strategy and resources when making the investment decision. It is important for the project to align with the organizational strategy and goals. It is also important to ensure that the company has the resources to sustain the project.