FIN 330 Module 5 Capital Budgeting Assignment Example

Capital Budgeting Analysis of the Propane Ice Machine Line

[Student Name]

Southern New Hampshire University

FIN 330: Corporate Finance

Module Five Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Capital Budgeting Analysis of the Propane Ice Machine Line

Introduction

The company's chief executive wants to build a line of compact propane-cooled ice machines for bars, cafés and small restaurants, a segment where the company sells little today. Federal limits on high-warming refrigerants under the American Innovation and Manufacturing Act are pushing buyers toward equipment using natural refrigerants such as propane (U.S. Environmental Protection Agency, 2023). This paper estimates the project's incremental cash flows over ten years, evaluates them with the company's 9.7 percent cost of capital from Project One and an 11 percent stress rate, and identifies the assumptions that drive the result.

What Counts

A cash flow enters this forecast only when the go-ahead decision itself would alter it. Three items are excluded. The $1.2 million already spent on prototypes and the $0.4 million market survey are sunk: they cannot be recovered whether the project goes ahead or not. Interest on any borrowing is excluded because the 9.7 percent discount rate already reflects the cost of financing; deducting interest as well would count it twice. Corporate overhead allocated to the line is excluded unless it actually increases, which the controller confirms it will not.

Two items are included. The project needs $9 million of working capital for inventory and receivables, invested at the start and recovered at the end. And the line would occupy an empty bay at the Fort Wayne plant that a neighboring distributor has offered to lease for $500,000 a year. Using the bay gives up that rent, so it is an opportunity cost.

Assumptions

Equipment costs $64 million and is depreciated straight-line over ten years for this analysis, or $6.4 million a year; Project Two will apply tax depreciation schedules. Sales start at 2,500 machines in year one as dealers stock the line, rise to 7,500 by year four and then grow about 2 percent a year to 8,400. The average price is $9,800. Variable costs are 66 percent of revenue, leaving a 34 percent contribution margin, in line with the company's existing undercounter models. Fixed cash costs are $7 million a year. The tax rate is 25 percent, and the first year's operating loss is assumed to reduce taxes on the company's other income.

Project cash flows ($ millions)

Each year's cash flow is operating income after tax plus depreciation. In year four, for example, revenue of $73.5 million produces a contribution of $25.0 million; subtracting fixed costs, the lost lease and depreciation leaves operating income of $11.1 million, or $8.3 million after tax, and adding back $6.4 million of depreciation gives $14.7 million. Year ten includes the $9 million of working capital recovered.

Decision Rules

At 9.7 percent, the present value of the cash flows exceeds the $73 million investment by $6.3 million. The IRR, which is the discount rate that would make NPV exactly zero, is 11.3 percent, above the cost of capital. The profitability index, the present value of inflows divided by the investment, is 1.09. Simple payback is 6.4 years and discounted payback 9.4 years. Because the cash flows turn from negative to positive only once, the project has a single IRR, and NPV and IRR give the same accept signal; with only one project under review, the conflicts that can arise between the two rules when ranking competing projects do not apply.

Decision measures

Graham and Harvey (2001) found that most chief financial officers use NPV and IRR, and many also look at payback. Here they send mixed signals: the project creates value, but most of it arrives late, and at the 11 percent stress rate recommended in Project One, the margin is thin.

Sensitivity

Changing one assumption at a time shows how fragile the result is. A 10 percent lower price turns NPV to minus $3.7 million. Variable costs at 70 percent instead of 66 percent give minus $5.5 million. Volumes 20 percent below forecast give minus $13.8 million, and a one-year delay in launch gives minus $10.2 million. Each of these is plausible. Koller et al. (2020) advise managers to spend their effort on the assumptions to which value is most sensitive, and here those are volume and the timing of launch.

Risk Beyond Sensitivity

Sensitivity analysis changes one input while holding the others fixed, but in practice the risks move together. If restaurants and bars cut spending in a recession, volumes would fall, dealers would push for discounts and the launch might be delayed, all at once. That combined downside is much worse than any single test above. The analysis also assumes no response from competitors, yet at least two rivals have announced propane models of their own, which could pressure prices within a few years. On the other side, the forecast gives no credit for dealers who might buy more of the company's other products once it offers a full propane range. Project Two will build full scenarios that move these assumptions together and assign rough probabilities to each.

Recommendation

On the base case, the project should be accepted: NPV is positive at the company's cost of capital and IRR exceeds it. But the result depends on volumes and timing that are uncertain, and modest shortfalls turn it negative. Project Two should test full scenarios, use tax depreciation and examine whether building in phases can limit the downside before the board commits $73 million.

Conclusion

The propane line clears the hurdle with an NPV of $6.3 million and an IRR of 11.3 percent, but with a long payback and high sensitivity to volume and timing. Brealey et al. (2023) describe NPV as the best single measure of whether a project adds value; here it says yes, narrowly, and the sensitivity analysis says the company should find ways to reduce the risk before approving.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2023). Principles of corporate finance (14th ed.). McGraw Hill.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Koller, T., Goedhart, M., & Wessels, D. (2020). Valuation: Measuring and managing the value of companies (7th ed.). Wiley.

U.S. Environmental Protection Agency. (2023). Phasedown of hydrofluorocarbons: Restrictions on the use of certain hydrofluorocarbons under subsection (i) of the American Innovation and Manufacturing Act of 2020 (88 FR 73098). Federal Register.