Sample FNCE623 Capital Budgeting Assignment Report 1

FNCE623 Capital Budgeting Assignment Report 1 Sample

The case is open ending. The way you collect data may affect the results. You must collect or estimate the related data if you can’t find them in the question.

THE ASSIGNMENT MUST BE DONE INDIVIDUALLY. ANY ACADEMIC INTEGRITY

ISSUES WILL BE REPORTED TO ACADEMIC OFFICE.

Vita Smart Ltd is a leading high-tech company which is incorporated in Surrey, BC. The company wants to add a lab equipment in Dec 2023. They hired you, a UCW graduate, to prepare a capital budgeting plan for the project. Do you recommend the company to accept the project or not?

Below is the information that your manager provided:

1. The approximate cost of the machine would be $210,000, with another $10,500 in shipping and handling charges. It would also cost an additional $2,0500 to install the equipment and $500 tuning fee.

2. The equipment would be set up in an unused space at the company’s main plant. The plant space could be leased out to another lab for $11,000 per year.

3. The machinery has an economic life of 5 years, but the manager didn’t know the CCA classification and CCA rate. He estimated that the machinery is expected to have a salvage value of $18,000 after 4 years of use.

4. The new product line would generate incremental sales of 1,350 units per year for 4 years and they are expected to grow 5% per year.

5. The variable cost per unit is estimated in $50 per unit in the first year. Each unit can be sold for $210 in the first year.

6. The sales price and cost are both expected to increase due to inflation. The fixed costs are estimated to be $90,000 per year and would increase with inflation. The manager ask you to do the research about the inflation rate in recent years.

7. The company hired 3 workers to operate the new equipment and provided them 100 hours paid training according to BC minimum wage. They will work on the production line 35 hours per week under a four year contract with a 15 working days paid leave. The manager estimated the inventory level will increase 5% of the total sales every year due to expansion. The accounting teams said the new project won’t affect A/R and A/P accounts in the future 4 years.

8. The company received $25,000 Research fund from BC government and decided to use 20% of them to do a market research on the new project.

9. The manager has concerns about the potential effects on other products when introducing the
new equipment. Currently, he estimated a 2.5% decrease in sales revenue.

10. The firm is a small business which taxable revenue under $300,000. The project is considered by the financial department to be as risky as the company. The financial department has estimate that the total WACC is 12% including $8,000 interest paid every year.

Requirements

Part I: Project analysis. Total 85 marks. Q1: 8 marks, Q2-Q12, 7 marks.

Write 4 or more complete sentences for each question in a Word file. Do not write in an essay format.

References are not necessary unless the questions require. No word limitation in this part.

1. State the steps and process of Capital Budgeting.

2. What are the principles in determining incremental cash flows?

3. What’s the definition of sunk cost? Which cash flow(s) is the sunk cost in the case and why?

4. What’s the definition of opportunity cost? Which cash flow(s) is the opportunity cost in the case and why?

5. What’s the definition of externality? Which cash flow(s) is the externality in the case? Are they positive or negative?

6. What’s definition of NOWC? Which cash flow(s) reflect the change of NOWC in the case?

7. What’s CCA in Canadian accounting practice. Estimate the CCA class of the asset in the case and explain.

8. What are CCA claim methods according to CRA guidance?

9. Why is the interest included in the cash flow estimation? What’s the current interest rate of business loan in BC now? Include reference website(s) where you obtain the data.

10. Is wage a direct cost or an indirect cost? How mush is the minimum wage in BC currently?
Include reference website(s) where you obtain the data.

11. Why is tax shield important in a business operation? How much is business tax rate in BC and Federal? Include reference website(s) where you obtain the data.

12. Will inflation be included in cash flow estimation? What’s most recent inflation rate in Canada?
Include reference website(s) where you obtain the data.

Part II: Project Evaluation. (Total 15 marks)

Using an Excel spreadsheet:

• Find the NPV of the project by using the pro forma financial statement method to determine cash flows.

• Set up the necessary equations by referencing to the input variable cells. The spreadsheet must be formula driven; do not put any numbers in equations, must use cell references.

• Use Excel’s built-in functions wherever possible

Present this assignment in a professional way. It is your responsibility to communicate clearly to the marker.

Solution

Part 1:

1. Steps of capital budgeting

The steps of capital budgeting will include a thorough analysis of the business and how it is going to conduct the business operations over the period. For Assignment Help, Here, for the capital budgeting purpose, the chronological steps should be taken into consideration in the ascending order:

1. Idea generation

2. Proportional for the project where the formal understanding of the potential risk will be identified.

3. Estimation of cash flow: in the cash flow estimation, the overall project analysis will be done. This is because, the effectiveness and the efficiency of the cash flow assumptions will help the organization to improve the company's financial performance.

4. Project evaluation: In this segment, the application of the capital budgeting tools, such as the net present value analysis, internal rate of return, payback period and others, will be calculated, The analysis will provide a detailed understanding of the profitability and another solvency related aspect of the investment.

5. Project selection and ranking: based on the outcomes of the project evaluation process, if the company is considering multiple opportunities, then it will rank the project depending on the profitability and another aspect, which will help the company to select the best and most preferred option.

2. The principles of determining the incremental cash flow:

Determining the incremental cash flows provides a critical step in the capital budgeting process. It involves the identification of the cash flows, which are directly related to any particular investment project because of the additional inclusion in operations. The implementation of the revenue will help the organization to understand how efficiently the project can do and add profit to the shareholder's value.

The principles of determining the incremental cash flows for the business are discussed

1. Relevance: the first preference for determining the incremental cash flow will include the relevance, which will consider that only the relevant income and expenses should be included for the evaluation purpose. Hence, the sunk cost should be eliminated.

2. Time horizon: One of the basic aspects for determining the incremental cash flow will include the time horizon determination, which is the defined period at which the company can generate the incremental cash flow out of the business.

3. Differential principle: The differential principle will include the incremental cash flows directly related to a particular project and not being generated in response to any other project.

4. Opportunity cost: For the incremental cash flow generation, if the company sacrifices their existing revenue or substitutes the use of any particular asset that is used for a different purpose then it will be considered as an opportunity cost, and it should be considered as an expense.

5. Externalities: the externalities will record the side effects of the project, which will impact the performance of the already existing businesses or product sales. Certain externalities will have a positive or negative impact depending on the positioning of the business.

6. Taxes: the taxes are the incremental aspect of revenue, and they should be accounted for by determining the value of incremental cash flow.

7. Working capital movement: The movement in the working capital requirement for the business will be considered an essential aspect of the incremental cash flow.

8. Terminal value: The terminal value will be considered as the amount of cash flow generated or spent on the closure of the proposed investment.

3. Definition of sunk cost and which cash flows should be considered as sunk cost for Vita Smart Ltd.

Definition

The sunk cost can be considered as the expense that is already incurred, and it will not be recovered.

cash flow, which should be considered as sunk cost

Here, the market research cost is taken from the grant for $5000. It is considered as the sunk cost because it has no relation with the acceptance or rejection of the project.

4. Definition of opportunity cost: cash flow that should be considered the opportunity cost for Vita Smart Ltd.

Opportunity cost

The opportunity cost can be considered as the expense for forgiving any opportunity to generate any alternative income because of the selection of any particular project. For the instrumental cash flow calculation, the opportunity cost should be considered as an expense for the business as the company is forgiving the chances of generating an alternative revenue because of the new investment.

Opportunity cost for the project:

In the given case scenario, the leasing of the land will be considered as the opportunity cost. This is because, the company was the opportunity to lease the place for $11000 per year.

5. Definition of externality, which cash flows should be considered externality and the given case scenario and the assessment of their positive and negative aspects.

Definition of externality

For the incremental cash, the determination of any project's externalities suggests a particular project's impact on other project revenue. There will be positive or negative externalities because of the particular project. Suppose any particular project is increasing the revenue of the alternative products available for the business. In that case, it will be considered a positive externality. On the contrary, if the project minimizes the sales revenue of other projects, then it will be considered as an negative externality.

Externalities for the proposed plan

Based on the calculation and the information provided by the company, the decrease in the revenue by 2.5% will be considered as the externalities for the business, and it will be considered as the negative externality. Here, the case study is silent about the sales revenue for the alternative project. Therefore, the current forecast of its sales is considered as the basis of the decrease in revenue for the other projects.

6. Definition of NOWC, cash flow indicating the NOWC:

Definition:

NOWS stands for the net operating working capital for the business. It is an expense, which will be employed in the accounts that are receivable and inventory and the accounts that are payables will partially finance it. In most of the cases, it is assumed that the entire working capital invested into the business will be recovered at the terminal period.

NOWC for the company

In the given case scenario, because of the increase in revenue, the working capital requirement for the business is increased by 5% every financial year as compared to the previous financial year's working capital requirement.

7. CCA in Canadian accounting practice, and the estimation of the class of assets in accordance with CCA:

The term CCA, in accordance with Canadian accounting practices, will be considered as the capital cost allowance, which is available for deduction in taxation purposes. It is an expense of the business for the capital expenses made by the organization. Here, CCA has been classified into different kinds of classes of assets.

Class of asset as defined with a specific rate of capital and available for the financial year:

Determination of the class of asset:

Based on the information available for the asset, it will be a class 8 asset, which includes specific property that is not included in another class of asset, like furniture and appliances and costing more than $500. The applicable cca for the "class 8" assets is 20%.

8. the CCA claim methods in accordance with the CRA guidance:

In accordance with the CRA guidelines, the organization can use the capital cost allowance in the following method

- Straight line method: Under the straight line method, the company will be getting the same amount of capital cost allowance, which can be calculated by deducting the salvage value from the cost of acquisition and it will be divided by the period or the life of the asset.

- Diminishing balance method: Under the diminishing balance method, the company will use the undepreciated capital cost multiplied by the diminishing balance rate.

- Double declining balance method: Under the double declining balance method, the company will use the double depreciation of the straight-line method as the initial percentage for getting the maximum depreciation in the initial years.

In order to claim the capital cost allowance in accordance with the Canadian income tax rules, the depreciation can be claimed by using the form t2125, which is the statement of the business and professional activities. At first, the company will require to identify the class of asset and the depreciation rate for the same as it to claim the capital cost allowance (www.canada.ca, 2023).

9. The interest included in the cash flow estimation and the current interest rate of the business loan in BC:

The interest expenses should be included in the cash flow estimation because it is an integral part of the cash outflow, which is relevant for a particular project itself. For instance, if the organization has included debt financing for the capital resourcing of the particular project, then it will be required to pay for the interest expenses, which will be specific to this project itself, and it will make a significant cash outflow out of the business. Hence the interest expense should be included in the cash flow consideration.

However, if the management applies the wacc as the discounting rate, then, the company is considering the cost of debt financing account as the way to average the cost of capital, including the weight of debt capital. Hence, the company is automatically considering the cost of interest for the project discounting purpose. However, if the company is not using the average cost of capital, then in such a case, the company will be required to include the interest expenses as an expense in the cash flow estimation.

The interest rate in British Columbia

The average interest for British Columbia is almost 5.25% for small-scale organizations. However, the interest will depend upon the liquidity position and other aspects of the business (tradingeconomics.com, 2023).

10. Assessment of the wage's expenses, determination of the minimum wages in BC

Assessment of the wage expenses

The wages can be direct and indirect depending on the nature of expenses. In the given case scenario, each employee worked a hundred 1835 hours over the period, which includes 35 hours of weekly working along with 15 days of week off, which is the total payment for 2345 hours. The wage expenses in the case study are a direct expense because these wages are paid for operating production equipment.

The correct minimum wage rate in British Columbia is $16.75 (news.gov.bc.ca, 2023).

At the same time, here and in many cases, the wages can consider as indirect costs if the wages costs are not associated with the production.

11. Importance of tax shield for the business operation and determination of the business tax rate in BC:

The tax shield can be considered as the items for which the company can get the deduction for taxation purposes. Because of those expenses, the company's tax liability will be reduced. However, for sure, it is like depreciation. The tax shield will minimize the tax expenses for the business, and there will be no cash flow for the same.

In accordance with the small business organization, the applicable business tax rate in British Columbia is 9% only (www.canada.ca, 2023).

12. Inclusion of the inflation in the cash flow estimation and the most recent inflation rate in Canada

Inflation is an integral part of the cash flow estimation because it will impact the cash generation process because of the general increase in the prices for the product. Therefore, the inflation should be adjusted with all expenses like the increase in revenue order product prices, direct material expenses, overhead expenses and others.

Considering the recent year inflation trend, it is identified that in recent financial years, inflation has increased by a significant portion because of global volatility. However, it will not exist in the future. Hence, for a better understanding of the situation, the 5-year average inflation, which is 3.27%, is considered (ycharts.com, 2023).

Part 2: project evaluation

Finding the net present value (NPV):

For the investment analysis purpose, the net present value will be used where the project cash flows will be discounted by the cost of capital, which is 12%. Suppose the present value of the future cash inflow is more than the cash outflow at the present value. In that case, the project can be considered for investment purposes because then it will serve the minimum required rate of return to the investor (pienaar, 2021). Based on the calculation, it is identified that the project identified by Vita Smart Limited cannot be selected because it is generating a negative net present value of $229120.04.

Reference