Pet Pamper: Capital Budgeting (Other (Not Listed) Sample)

Pet Pamper Ltd.
Management Report
Background of the problem
With intense pressure to optimize the share price, Pet Pamper Ltd has identified various projects it can profitably engage in. These include M/s Smith’s inventory processing efficiency improvement and inventory holding time reduction projects (Projects A & B), carpet and vinyl office refurbishment projects (Project C & D respectively), and the water-loving dogs manufacturing project (Project E). The scope of this report revolves about the establishment of a suitable approach of systematically selecting the most suitable capital budgeting approach. With the shareholder interest in mind, the optimal capital budgeting approach selected will aim at optimizing the company’s profitability. Profitability of the company’s operations will lead to an ultimate increase in the earnings per share.
The feasible options
There are various approaches to capital budgeting approaches accessible to Pet Pamper Limited. For optimal performance, the approach selected for use should give optimal returns to the company, have minimal risk exposure for the company or lead to cost reduction. Among these approaches is the Net Present Value (NPV) approach, the Internal Rate of Return Approach and the Payback Period Approach. A further selection criterion will be based on the overall effect of the approach on the long-term profitability of the company.
Synthesis of various systematic approaches
1 The Net Present Value (NPV) Approach
This is a time-value of money based approach that evaluates the company’s profitability based on an individual project’s feasibility and profitability. Under the approach, the project with the highest present value of future cash inflows net of the cash outflows is considered. As an evaluation and investment measurement factor, the interest rate of return for the project is assumed to be equivalent to the risk free rate of return or the interest rate on debt. In essence, Pet Pumper’s interest rate will be 12% p.a. (3,000,000/25,000,000*100%).
Assumptions of the approach
Under the approach, we assume M/s Smith’s assumptions on the cash flows are certain and assured with negligible deviation, if any. Since the approach is anchored on the presence of cashflows (both in and outflows), the certainty of the assumed future cash in and outflows is essential as it avoids the requirement to revalue the project and further that the returns realized throughout the project life are reinvested at the same rate of return. Since the project accounting takes place at the end of the project’s fiscal year and on its completion, this approach further requires prudent assumption that the cashflows are realized either at the end or the beginning of the fiscal year. A further assumption is that the impact of inflation on the project cashflows is insignificant and that the operations of the project are not subject to taxation. This is essential as it allows for objective evaluation of all Pet Pamper’s projects with the projected cashflows with putting provisional budgetary allocations for inflation and taxation.
Project NPVs
The NPV of the projects is computed as follows:
NPV = CF0(1+r)0 + Σ{CFi((1+r)n} where CF0 is the initial cash outflow, r the interest rate and {CFi((1+r)n the individual net cash flows realized after the initial cash outflow of amount CFi at time i=1,2,3…n.
Project A
NPV = -5.5(1.12)0+4.3(1.12)1+0.2(1.12)2+3.6(1.12)3 = $4.6246208 M.
Project B
NPV = -23(1.12)0+16(1.12)1+0.8(1.12)2+14.5(1.12)3= 16.294976 M.
Project C & D
For project C & D, there are no directly positive cash flows associated with the project. Therefore, they cannot be evaluated by the NPV approach.
Project E
Under the water-loving dogs manufacturing project, Pet Pamper Ltd obtains a 5-year licensing from the shark and crocodile developers at a $5 royalty per unit sold. The initial sale price per product will be $200.Prior to the onset, a market pretesting of the product will also be done at an initial marketing cost of $30,000.
Year

Annual Sales

Revenue

Royalties/fees

Marketing cost

Net Profit before tax

0

-25,500,000

-

-100,000

-30,000

-25,630,000

1

175,000

35,000,000

875,000

1,000,000

33,125,000

2

200,000

40,000,000

1,000,000

600,000

38,400,000

3

150,000

30,000,000

750,000

300,000

28,950,000

4

60,000

12,000,000

300,000

300,000

11,400,000

5

35,000

7,000,000

175,000

100,000

6,725,000

Thus, the NPV for Project E will be:
NPV = -25.63(1.12)0+33.125(1.12)1+38.4(1.12)2+28.95(1.12)3+11.4(1.12)4+6.725(1.12)5 =$130,101,494.1
Remark
By NPV approach, project A, B and E have NPVs>0, thus viable. However, project E would be accepted as it has the highest net present value.
2 The Internal Rate of Return (IRR) Approach
The internal rate of return, i, is the interest rate at which the project repays its initial investment as to match the initial cash outflow. I.e. At the interest rate, i, the NPV of the project yields to zero. With its core merit being that it highlights the return resulting from the project, if i is higher than the cost of capital, the project is adopted. Else, it is rejected. Here, the project is only accepted is the rate of return, i>12%.
Project A
IRR = -5.5(1+i)0+4.3(1+i)1+0.2(1+i)2+3.6(1+i)3 = 0
Trying i=10%,
IRR (10%) = -25.63(1.1)0+33.125(1.1)1+38.4(1.1)2+28.95(1.1)3+11.4(1.1)4+6.725(1.1)5 =$123.33253698
Tryingi=5%,
IRR (5%) = = -25.63(1.05)0+33.125(1.05)1+38.4(1.05)2+28.95(1.05)3+11.4(1.05)4+6.725(1.05)5 =$107.74402585
Thus, i must be below 5%.By linear interpolation,
Project B
IRR = -23(1+i)0+16(1+i)1+0.8(1+i)2+14.5(1+i)3 = 0
Trying i=10%,
IRR (10%) = -23(1.10)0+16(1.10)1+0.8(1.10)2+14.5(1.10)3 = $4.2636
Trying i=5%,
IRR (5%) = -23(1.05)0+16(1.05)1+0.8(1.05)2+14.5(1.05)3 = 3.40295
Thus, i must be below 5%. By linear interpolation, i=
Project C & D
For project C & D, there are no directly positive cash flows associated with the project. Therefore, they cannot be evaluated by the IRR approach.
Project E
IRR = -25.63(1+i)0+33.125(1+i)1+38.4(1+i)2+28.95(1+i)3+11.4(1+i4+6.725(1+i)5
Trying i=10%,
IRR (10%) = -25.63(1.1)0+33.125(1.1)1+38.4(1.1)2+28.95(1.1)3+11.4(1.1)4+6.725(1.1)5 =$123.33253698
Trying i=5%,
IRR (5%) = = -25.63(1.05)0+33.125(1.05)1+38.4(1.05)2+28.95(1.05)3+11.4(1.05)4+6.725(1.05)5 =$107.74402585
Thus, i must be below 5%.By linear interpolation,
3 The Payback Period Approach
For firms with urgent need for share price optimization, there is need to have high cash conversion ratio throughout the various projects they undertake. Pet Pamper shareholders expect an improvement in the dividend payout for their shares. An efficient way of maintaining a balance between capital projects, its profitability and conversion ratio is by investing in projects with short and certain initial investment recouping period. This way, Pet Pamper can fund most other activities with longer project life. In essence, the payback time is the time it takes for Pet Pamper to have the cash inflows generated from a project match the project’s initial cash outflow (Singh, Jain, & Yadav, 2003).
Assumptions of the Payback period approach
Under this approach, it is assumed that there are no significant cash flows after they payback period of the project. With this said, it becomes challenging in determining the profitability of a project with certainty under the approach (ActEd, 2015).
Project Payback periods
Project A
Year

0

1

2

3

Cashflow ($ Millions)

(5.5)

4.3

0.2

3.6

Cumulative cashflows

(5.5)

(1.2)

(1.0)

2.6

Thus, the payback period = {2 + (1.0/3.6)} years = 2.2778yrs
Project B
Year

0

1

2

3