Explanations of results of capital budgeting methods

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Assignment -

PENTAG Company produces small powerboats and faces the challenge to build and market an environment-friendly green powerboat. Dr Pascal Goulpie, the director of PlanetSolar, stated that building an environment-friendly boat is possible for sure, but the market and demand are still niche right now. Many experts believe that resin-infusion technology will lead the industry for cleaner powerboats in future; however, that will take long time. However, PENTAG is not relying on that new technology to build greener powerboats. Rather, the company is now evaluating a new project to produce Q-powerboats that will leave an excessive carbon footprint in the water.

PENTAG invested $50,000 in the last year for designing its Q-powerboat. An additional $100,000 was incurred to promote the boat to a number of distributors. However, considering a few major changes in the previous estimates, the Chief Financial Officer (CFO) of PENTAG Company has instructed to re-evaluate the project. The following further revised estimates are provided relating to this Q-powerboat project.

The company requires an additional plant for building the Q-powerboat and the plant can be procured from a local importer at a cost of $20,000,000. Additional transportation and installation cost would be $800,000. The plant would have an economic life of six years and will be depreciated using a straight line rate of 12 per cent for tax purposes. At the end of the project life of six years, the plant is estimated to be sold for $3,000,000.

In addition to the plant, the project will require an initial investment in stock (inventory) of $500,000. Furthermore, the projected amount tied up with debtors (accounts receivable) would be $380,000 and it would be partially offset by $180,000 increase in creditors (accounts payable). There will be no further investment in net working capital (NWC) until its final recovery at the end of the project life.

Considering positive responses received during promotional programs, and the economy price of $30,000 per boat only, sales manager of PENTAG is very optimistic about selling 650 Q-powerboats in the first year. Due to competition and water pollution issues, annual sales will decrease by 50 boats every year during the remaining life of the project. Within the range of producing 300 to 700 boats per year, variable cost of production is estimated to be 40% of sales revenue. The company will produce boats equal to the number of sales units estimated in a year. Head office of the company will allocate $200,000 for fixed factory overhead per year to this production plant.

PENTAG Company is planning to finance this project by issuing 10% debenture of $10 million, and the remaining required investment would be financed by equity. Selling Q-Powerboat will also increase annual sales of powerboat parts by $500,000. Cost of production for these parts would be 40 per cent of sales revenue from parts. Starting the Q-Powerboat project will stop other monthly earnings of $10,000 from the production facility of the PENTAG Company.

The company uses required rate of return considering its weighted average cost of capital (WACC) that varies from 20 to 25 per cent in recent times. Management has decided to use 20 per cent required rate to evaluate this project. Corporate tax rate is 30%. The required discounted payback period is 4 years.

A new environment protection group, Save the Waterways, is trying to negotiate with the management of PENTAG Company to stop the Q-Powerboat project due to its excessive carbon emissions. In this context, company managers have identified another S-Powerboat project that would be relatively more environment-friendly. Initial investment for this S-Powerboat project would be the same as the Q-Powerboat project and projected future cash flows would be as follows:

Year-1: $6,400,000; Year-2: $7,400,000; Year-3: $7,900,000;

Year-4: $8,600,000; Year-5: $9,300,000; Year-6: $11,100,000;

Before making a final decision in the upcoming meeting, the CFO of PENTAG Company requires a clear explanation of all relevant issues relating to the Q-Powerboat project. In particular, a formal report is enquired by the CFO to include a detail analysis of cash flows and explanations of results of capital budgeting methods that are commonly used in evaluating projects.

Furthermore, in a separate section in the report, the CFO is interested to review the details of the comparison between the Q-Powerboat and S-Powerboat projects with respect to the results of capital budgeting methods using both 20 and 25 per cent required rates, crossover rate and all relevant factors that can assist in making the final decision.

Note - Like an excel spreadsheet analysis with a table of cash flow using excel formulas where appropriate.

Reference no: EM132304353

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