Capital Budgeting Analysis of EMU Electronics

Question: Describe about the Capital Budgeting Analysis of EMU Electronics. Answer: Introduction EMU Electronics is considering production of a new smart phone which will have all the features of the old smart phone plus a new Wi-Fi tethering feature. A capital budgeting analysis has been performed to help in deciding whether to go ahead with the project or not depending on its viability and profitability. Capital Budgeting Analysis The costs of developing a prototype has not been considered in the analysis as it is a sunk cost and will not affect the projects future cash flows. Also the cost incurred in marketing research is considered a sunk cost and hence is not a part of the analysis. The table of net operating cash flows is given below: Year 0 1 2 3 4 5 Equipment cost $3,45,00,000.00 Sales Volume 64000 106000 87000 78000 54000 Selling price $485.00 $485.00 $485.00 $485.00 $485.00 Revenues $3,10,40,000.00 $5,14,10,000.00 $4,21,95,000.00 $3,78,30,000.00 $2,61,90,000.00 Variable costs per unit $205.00 $205.00 $205.00 $205.00 $205.00 Variable costs $1,31,20,000.00 $2,17,30,000.00 $1,78,35,000.00 $1,59,90,000.00 $1,10,70,000.00 Fixed costs $51,00,000.00 $51,00,000.00 $51,00,000.00 $51,00,000.00 $51,00,000.00 Depreciation $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 EBIT $78,91,428.57 $1,96,51,428.57 $1,43,31,428.57 $1,18,11,428.57 $50,91,428.57 Income tax @30% $23,67,428.57 $58,95,428.57 $42,99,428.57 $35,43,428.57 $15,27,428.57 Operating income after tax $55,24,000.00 $1,37,56,000.00 $1,00,32,000.00 $82,68,000.00 $35,64,000.00 Add back depreciation $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 Operating cash flow $1,04,52,571.43 $1,86,84,571.43 $1,49,60,571.43 $1,31,96,571.43 $84,92,571.43 cash outflow for NOWC $62,08,000.00 Sale proceeds after tax $68,07,142.86 Recovery of NOWC $62,08,000.00 Project free cash flow -$3,45,00,000.00 $42,44,571.43 $1,86,84,571.43 $1,49,60,571.43 $1,31,96,571.43 $2,15,07,714.29 Discount rate 12% $1.00 $0.893 $0.797 $0.712 $0.636 $0.567 Present value of cash flows -$3,45,00,000.00 $37,89,795.92 $1,48,95,225.95 $1,06,48,639.24 $83,86,659.72 $1,22,04,054.69 Working Notes Depreciation Equipment cost $3,45,00,000.00 Useful life 7 years Depreciation = equipment cost / useful life =34500000 / 7 =$49,28,571.43 Terminal Value Equipment cost $3,45,00,000.00 Depreciation $49,28,571.43 Book value at end of five years $98,57,142.86 Salvage value $55,00,000.00 Loss on sale -$43,57,142.86 Tax benefit -$13,07,142.86 After tax proceeds $68,07,142.86 Payback period Year Project free cash flow Cumulative cash flows 0 -$3,45,00,000.00 -$3,45,00,000.00 1 $42,44,571.43 -$3,02,55,428.57 2 $1,86,84,571.43 -$1,15,70,857.14 3 $1,49,60,571.43 $33,89,714.29 4 $1,31,96,571.43 $1,65,86,285.71 5 $2,15,07,714.29 $3,80,94,000.00 Payback period = 2.8 years Profitability index = sum of discounted cash flows / initial investment = 1.4 IRR IRR = 26% NPV NPV = $1, 54, 24,375.51 Sensitivity of NPV to price changes For the purpose, we have assumed a fall in price of the smart phone by 10% and the change in NPV as a result. Year 0 1 2 3 4 5 Equipment cost $3,45,00,000.00 Sales Volume 64000 106000 87000 78000 54000 Selling price $436.50 $436.50 $436.50 $436.50 $436.50 Revenues $2,79,36,000.00 $4,62,69,000.00 $3,79,75,500.00 $3,40,47,000.00 $2,35,71,000.00 Variable costs per unit $205.00 $205.00 $205.00 $205.00 $205.00 Variable costs $1,31,20,000.00 $2,17,30,000.00 $1,78,35,000.00 $1,59,90,000.00 $1,10,70,000.00 Fixed costs $51,00,000.00 $51,00,000.00 $51,00,000.00 $51,00,000.00 $51,00,000.00 Depreciation $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 EBIT $47,87,428.57 $1,45,10,428.57 $1,01,11,928.57 $80,28,428.57 $24,72,428.57 Income tax @30% $14,36,228.57 $43,53,128.57 $30,33,578.57 $24,08,528.57 $7,41,728.57 Operating income after tax $33,51,200.00 $1,01,57,300.00 $70,78,350.00 $56,19,900.00 $17,30,700.00 Add back depreciation $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 Operating cash flow $82,79,771.43 $1,50,85,871.43 $1,20,06,921.43 $1,05,48,471.43 $66,59,271.43 cash outflow for NOWC $55,87,200.00 Sale proceeds after tax $68,07,142.86 Recovery of NOWC $55,87,200.00 Project free cash flow -$3,45,00,000.00 $26,92,571.43 $1,50,85,871.43 $1,20,06,921.43 $1,05,48,471.43 $1,90,53,614.29 Discount rate 12% $1.00 $0.893 $0.797 $0.712 $0.636 $0.567 Present value of cash flows -$3,45,00,000.00 $24,04,081.63 $1,20,26,364.34 $85,46,289.51 $67,03,744.29 $1,08,11,532.44 NPV = $59, 92,012.2 Particulars Original New % change Price $485 $436.5 10% NPV $1,54,24,375.51 $59,92,012.2 61% NPV is highly sensitive to the price as with a decrease in price by 10%, NPV decreases by 61%. Sensitivity of NPV to quantity sold changes For the purpose, we have assumed a fall in quantity of the smart phone by 10% and the change in NPV as a result. Year 0 1 2 3 4 5 Equipment cost $3,45,00,000.00 Sales Volume 56220 98220 79220 70220 46220 Selling price $485.00 $485.00 $485.00 $485.00 $485.00 Revenues $2,72,66,700.00 $4,76,36,700.00 $3,84,21,700.00 $3,40,56,700.00 $2,24,16,700.00 Variable costs per unit $205.00 $205.00 $205.00 $205.00 $205.00 Variable costs $1,15,25,100.00 $2,01,35,100.00 $1,62,40,100.00 $1,43,95,100.00 $94,75,100.00 Fixed costs $51,00,000.00 $51,00,000.00 $51,00,000.00 $51,00,000.00 $51,00,000.00 Depreciation $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 EBIT $57,13,028.57 $1,74,73,028.57 $1,21,53,028.57 $96,33,028.57 $29,13,028.57 Income tax @30% $17,13,908.57 $52,41,908.57 $36,45,908.57 $28,89,908.57 $8,73,908.57 Operating income after tax $39,99,120.00 $1,22,31,120.00 $85,07,120.00 $67,43,120.00 $20,39,120.00 Add back depreciation $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 $49,28,571.43 Operating cash flow $89,27,691.43 $1,71,59,691.43 $1,34,35,691.43 $1,16,71,691.43 $69,67,691.43 cash outflow for NOWC $54,53,340.00 Sale proceeds after tax $68,07,142.86 Recovery of NOWC $54,53,340.00 Project free cash flow -$3,45,00,000.00 $34,74,351.43 $1,71,59,691.43 $1,34,35,691.43 $1,16,71,691.43 $1,92,28,174.29 Discount rate 12% $1.00 $0.893 $0.797 $0.712 $0.636 $0.567 Present value of cash flows -$3,45,00,000.00 $31,02,099.49 $1,36,79,600.95 $95,63,259.77 $74,17,570.91 $1,09,10,582.48 NPV = $1, 01, 73,113.06 Particulars Original New % change Quantity sold 3,89,000 units 3,50,100 units 10% NPV $1,54,24,375.51 $1,01,73,113.06 34% Though NPV is sensitive to changes in quantity sold, however it is more sensitive to changes in the price. Recommendation Yes, EMU should produce the new smart phone as the project has a positive NPV, IRR is more than the required rate of return of 12%, the payback period is less than 5 years and the profitability index is more than 1. Effect of loss of sale of old models A loss of sale of other models due to introduction of the new model will have adverse effects on the analysis. The loss of sale will be regarded as an opportunity cost and will be treated as an expense and reduced from the revenue. This will reduce the operating income and operating cash flows, thus reducing the NPV of the project.