Capital Budgeting Techniques to Marketing Operations

Question: Discuss about the Capital Budgeting Techniques to Marketing Operations. Answer: Introduction: The capital budgeting method is a very effective method for evaluating the potentiality of various projects over the long period. In capital budgeting, there are several techniques, used for comparing the profitability of the projects. Accounting rate of return, payback period, net present value and internal rate of return are few most accomplished and popular techniques of capital budgeting. The five projects of the company are also compared under these four methods. Accounting Rate of Return and Payback Period: The accounting rate of return describes the rate of return, provided by any project over the long period, as per the accounting records. It is calculated on the basis of the net accounting profit or earnings of the project. The project with higher ARR is considered more profitable. Payback period can be stated as the period, within which, the investor can earned back the initial investment from the net earnings of the project. The project with shorter payback period is always more preferable by the investors (Bierman Jr and Smidt 2012). The ARR and the payback period of the five projects are calculated in the following table: Calculation of ARR and Payback Period Particulars Supplier A Supplier B Supplier C Supplier D Supplier E Average Annual Income $16,600 $16,000 $22,800 $16,800 $16,000 Less: Operating Expenses ($2,000) ($1,200) ($1,600) ($1,300) ($1,300) Less: Depreciation Expenses ($13,600) ($10,800) ($13,800) ($12,800) ($11,800) Annual Savings before Tax $1,000 $4,000 $7,400 $2,700 $2,900 Less: Tax @30% ($300) ($1,200) ($2,220) ($810) ($870) Net Annual Savings $700 $2,800 $5,180 $1,890 $2,030 Add: Depreciation $13,600 $10,800 $13,800 $12,800 $11,800 Net Annual Cash Savings $14,300 $13,600 $18,980 $14,690 $13,830 Initial Cost $75,000 $60,000 $74,000 $70,000 $65,000 Residual Value $7,000 $6,000 $5,000 $6,000 $6,000 Accounting Rate of Return 1.71% 8.48% 13.11% 4.97% 5.72% Payback Period (in Years) 5.24 4.41 3.90 4.77 4.70 Net Present Value and Internal Rate of Return: Both the net present value and internal rate of return considers the time value of money for evaluating the potentiality of any project or return in the long run. Net present value is the present value of total net cash flow, generated by any project over the periods. The net cash flow also incorporates the initial investment and therefore, NPV can be described as the excess of the present value of total net cash inflows and cash outflow for initial investment. The project with positive and higher net present value is considered more potential than other projects (Kashyap 2014). Internal rate of return is the return rate at which the net present value of any project would be zero. In other words, it is the minimum rate of return, generated by the project. The investors always want higher IRR than the discount rate or cost of capital. However, amongst many projects, the project, which can generate higher IRR, is considered better option for investment than others (Grob 2013). The NPV and IRR of all the five projects are calculated below: Calculation of NPV IRR:- Supplier A Supplier B Supplier C Supplier D Supplier E Year Discount Rate Discounting Factor Net Cash Flow Discounted Cash Flow Net Cash Flow Discounted Cash Flow Net Cash Flow Discounted Cash Flow Net Cash Flow Discounted Cash Flow Net Cash Flow Discounted Cash Flow 0 8% 1 ($75,000) ($75,000) ($60,000) ($60,000) ($74,000) ($74,000) ($70,000) ($70,000) ($65,000) ($65,000) 1 8% 0.93 $20,000 $18,519 $19,000 $17,593 $28,000 $25,926 $20,000 $18,519 $19,000 $17,593 2 8% 0.86 $19,000 $16,289 $18,000 $15,432 $24,000 $20,576 $19,000 $16,289 $18,000 $15,432 3 8% 0.79 $18,000 $14,289 $17,000 $13,495 $26,000 $20,640 $18,000 $14,289 $17,000 $13,495 4 8% 0.74 $17,000 $12,496 $16,000 $11,760 $20,000 $14,701 $17,000 $12,496 $16,000 $11,760 5 8% 0.68 $18,000 $12,250 $16,000 $10,889 $21,000 $14,292 $16,000 $10,889 $16,000 $10,889 Net Present Value ($1,157) $9,170 $22,135 $2,482 $4,170 Internal Rate of Return -0.56% 5.41% 10.59% 1.29% 2.30% Conclusion: As per the calculations above, the five projects are ranked in the following table: Ranking Table:- ARR Payback NPV IRR Total Rank Supplier A 5 5 5 5 20 5 Supplier B 2 2 2 2 8 2 Supplier C 1 1 1 1 4 1 Supplier D 4 4 4 4 16 4 Supplier E 3 3 3 3 12 3 From the above table, it can be stated though all the projects fail to provide the expected internal rate of return, on the basis of the other outcomes, Supplier C can be considered as the most profitable venture amongst all the five projects. 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