Capital Budgeting Methods And Capital Investment Decisions

Based on

Rainbow Embroidery Limited

Submitted to:

Md. Jahangir Alam Professor, IBA, University of Dhaka

Submitted by: Group 12

June 23, 2013

June 23, 2013

Dr. Md. Jahangir Alam

Professor

Institute of Business Administration

University of Dhaka

Subject: Letter of Transmittal

Dear Sir,

We are pleased to submit this report to you as a requirement to our “Financial Management I”

course. In this report, we have used your lessons and guidance to explicate “Capital Budgeting

Methods and Capital Investment Decisions in Rainbow Embroidery Limited’s Project”.

We hope that every aspect of the report meets your expectations and are in accordance to your

instructions. We will be glad to answer any queries regarding the analysis of the project and the

contents of the report.

Sincerely,

Group 12, Section: B

BBA 20th Batch

Institute of Business Administration

University of Dhaka

Name Roll Number Signature

Sudipta Saha Turja (ZR – 95) _______________

Musharrat Rahman Chandrika (RH – 97) _______________

Hikmat Kabir (ZR – 99) _______________

Sayem Faruk (ZR – 128) _______________

Acknowledgements

First of all, we would like to thank the Almighty for giving us the ability to complete our report

on time. We would then like to convey our thanks to our respected and beloved course

instructor, Dr. Md. Jahangir Alam for his guidance throughout the making of the report. His

supervision and support have helped us a lot in the making of our report and it goes without

saying that the lessons he has taught us shall remain invaluable throughout our entire lives and

will immensely aid us in our respective careers. Lastly, we would also like to express our

gratitude towards Rainbow Embroidery for providing us with the foundation to build our

project.

Finally, we would like to stress again that whatever we have learnt while making this report will

be etched in our memories as a monumental experience and will aid us incalculably throughout

our lives.

Executive Summary

This report is done in order to determine the profitability and feasibility of a new project that is

to be undertaken by Rainbow Embroidery. Rainbow Embroidery is considered a leader among

its contemporaries when it comes to embroidered garments with Rainbow completing orders

for the jerseys of famous teams like FC Barcelona, Juventus, etc. The information needed to

facilitate the findings of the report were both obtained from primary sources, i.e. Rainbow itself

and other secondary sources such as the lectures provided to us by our honourable course

professor Professor Dr. Md. Jahangir Alam. However, limitations such as time and lack of some

proper information outlets such as a working website has hampered the ability of this report to

reach its full potential.

Rainbow Embroideries needs to expand the volume of its work in order to keep up with

competition both home and abroad. As such, they are considering the practicability of buying

30 machines composed of three different models. These machines are to be used for 10 years

with an estimated required rate of return at 16% after which they shall be sold off.

In order to ascertain the acceptability of this project, much extensive calculations were done in

order to come up with an accurate pro forma income statement and pro forma cash statement.

With the help of those, essential figures such as the Net Present Value, Profitability Index and

Internal Rate of Return were determined and then scrutinized in order to determine whether

the company should accept the project or not. At the end, it was decided that the company

should let go off this project since all three of the required figures were deemed to be

unsatisfactory as per the company’s requirement.

Table of Contents

Topic No. Topics Page No.

1.0

1.1

1.2

1.3

1.4

1.5

INTRODUCTION

Origin of the Report

Objectives of the Report

Scope of the Report

Methodology Used

Limitations

1 – 2

1

1

1

1

2

2.0 COMPANY AND FACTORY OVERVIEW 3 – 4

3.0 PROJECT OVERVIEW 5 - 6

4.0

4.1

4.2

CAPITAL BUDGETING METHODS AND CAPITAL

INVESTMENT DECISIONS

Capital Budgeting Methods

Capital Investment Decisions

7 – 8

7

8

5.0 ANALYSIS OF THE PROJECT 9 - 19

6.0 RECOMMENDATION 20

7.0 BIBLIOGRAPHY 21

1

1.0 Introduction

1.1 Origin of the Report The report was assigned to us as a part of the group assignment in “Financial Management I”

course by our course instructor Dr. Md. Jahangir Alam. The topic was assigned to us by the

course instructor and the company was selected by submitting a proposal to him.

1.2 Objectives of the Report To understand the applications of the methods of capital budgeting and capital

investment decisions

To relate the basic financial terms with real life industrial activities

To provide recommendations based on the analysis

1.3 Scope of the Report The report mainly focuses on four things:

1. The overview of Rainbow Embroidery as a company and the overview of the project

2. The financial information regarding the project

3. The analysis of the financial information using capital budgeting methods (Net Present

Value, Internal Rate of Return and Profitability Index)

4. The recommendation that will be provided in accordance to the results of the analysis

1.4 Methodology Used We have used both primary and secondary sources of data to make the necessary analysis

shown in the report.

1. Primary source: We have contacted one of the members of the board of directors of

Rainbow Embroidery, Mr. Joshim Chowdhury. He has greatly helped us by giving us the

necessary information regarding the project that they want to invest in.

2. Secondary source: The secondary source of information contains those valuable

lectures that our respected course instructor Dr. Md. Jahangir Alam has provided us.

2

They have been greatly used during the analysis and the notes are included in Section

4.0 of the report.

1.5 Limitations Certain limitations were faced while making the report and on the methodology used.

Being a small private limited company, Rainbow Embroidery did not provide us with its

financial statements which could have been used to strengthen our analysis on the

project.

The company does not have a working internet website from which we could have

gathered more vital information.

Presence of time constraint disallowed us to carry out full length interviews with

multiple officials of Rainbow Embroidery.

3

2.0 Company and Factory Overview

Rainbow Embroidery is currently among the industry leaders when it comes to extensive

embroideries and it uses cutting edge technology imported from Japan and China in order to

excel in quality when it comes to their products. Its factory is located in the Savar Export

Processing Zone, Dhaka which was established back in 1992. Rainbow Embroidery aims to lead

the market by providing superior quality products that offer high value addition and diversity

when compared to its rivals. The company puts a great emphasis on maintaining a customer

friendly service policy and it offers a one stop solution for business partners to provide with

garments and embroidery that excel in quality. The company has also expanded its reach into

the global arena as well.

The company was initially founded as a small factory with its sole focus in operating with the

domestic embroideries at a small scale. It grew under the care of Mr. Jashim Chowdhury, who

also happens to be one of the owners of the company. Under his guidance, the company grew

within a short span of only 10 years and started receiving orders from many countries for mass

production of garments like jerseys, t-shirts, trousers etc. Rainbow Embroidery also started

focusing on the making of logos and other intricate embroideries of official jerseys for teams

like that of FC Barcelona, Juventus FC, the Portugese National Team, Paris Saint Germain to

name a few (Source: (World Football News and Update, 2013)). At the same time they were

asked to work on official club merchandises such as the embroideries on club jerseys, caps, t

shirts, etc. The factory currently has several large units each of which specializes in different

parts of the whole production process.

The factory located is located in a green part of Savar and is an indication of the company’s

commitment to protect the environment. Its modern emission treatment plant ensures that the

effluents are properly treated before being released into the environment to protect the

surrounding areas for future generations. The company keenly follows all standard

environment guidelines producing modern, power efficient and less emission generating

machineries to minimize its impact on the environment. The company regards employee

4

satisfaction to be crucial in getting the best results. It provides comfortable accommodations,

meals, medical cares, group insurance and other employee welfare facilities in order to

maintain that goal. A safe and congenial working environment also ensures that workers are

well cared for and satisfied so that eventually they provide the customers with the best possible

products.

As per its mission, Rainbow Embroidery is committed to producing world class products while

encouraging the local industries to upgrade and meet global challenges. Today, it is on par with

the best manufacturers around the world. As a world class operation, Rainbow Embroidery

remains committed to satisfying customers with unwavering quality and unbeatable service.

5

3.0 Project Overview

As Rainbow Embroidery differentiates, it needs to expand its product volume. As our country

goes on its way to become a giant in the global garment industry, it needs to tackle more orders

of making jerseys that are coming at rapid pace to our country.

Due to this increased order of jerseys throughout the country, Rainbow Embroidery is planning

to invest in three different types of machines. These machines will be used to embroider logos

on the jerseys that will then be sold to the companies abroad from which subcontracts have

originally been received. The company intends to buy a total of 30 machines (there are three

different models of these machines).

Machine Model No. of machines to be bought Per unit cost of machine

Machine 1: Baruban

(Model: BEDFH#YN/YF#BF)

15 units BDT 70 lacs

Machine 2: Paajima KM

(Model: TFKM#920)

8 units BDT 70 lacs

Machine 3: Paajima FM

(Model: TFFM#920)

7 units BDT 45 lacs

Figure: Table 1

With these machines and the vision of expansion in their mind, Rainbow Embroidery can

embroider more units of jerseys. The total life of the project is 10 years as confirmed by Mr.

Joshim Chowdhury. At the end of these 10 years, the company intends to sell these machines at

the market values during that time. The required rate of return from the project is 16%. The

lives of the machines and their market values at the end of the stated period are given in the

following page.

6

Machine

Model

Machine Life Salvage Value (at end of

the life of the machine)

Market value

After 10 years After 20 years

Machine 1 20 years BDT 45 lacs BDT 61 lacs BDT 50 lacs

Machine 2 20 years BDT 42 lacs BDT 61lacs BDT 50 lacs

Machine 3 20 years BDT 18 lacs BDT 38 lacs BDT 20 lacs

Figure: Table 2

These figures given above will be used during an analysis of the project to see whether it is

feasible and profitable or not. Along with this information, a further set of information which

will be used during the analysis of the project are given below.

Components Amounts

Selling price of embroidered jerseys (BDT per unit) BDT 24

Per unit variable cost of embroidering (BDT per unit) BDT 12

Total overhead rate (BDT per unit) BDT 15

Operating time of the machines (hours per day) 14 hours per day

Number of embroideries in an hour using each machine 40 units

Figure: Table 3

7

4.0 Capital Budgeting Methods And Capital Investment Decisions

4.1 Capital Budgeting Methods

Net Present Value Method:

It is the present value of all cash inflows minus the initial investment.

If NPV is positive the project is accepted. If NPV negative, the project is rejected.

Profitability Index:

It is the sum of the present values of all cash inflows divided by initial investment.

If profitability index is greater than 1, the project should be accepted. If it is less than 1, the

project should be rejected.

Internal Rate of Return:

It is the rate of return from the project. It is the discount rate at which the sum of present

values of all cash inflows equals initial investment.

If IRR is greater than the required rate of return, project is accepted. If it is less than the

required rate of return, the project is rejected.

8

4.1 Capital Investment Decisions

Capital Investment Decisions:

To evaluate a project, a firm requires to estimate of related items of a project. They may be:

1. Total investment required

2. Working capital requirement

3. Quantity to be sold

4. Unit selling price

5. Unit variable cost

6. Fixed cost

Pro forma financial statements:

In evaluating a project it is required to prepare projected financial statement. This projected

financial statement is called pro forma financial statement. It is the financial statement

projecting future year’s operations.

Pro forma cash flow statement:

Project cash flow = Project operating cash flow – Addition to capital spending – Addition to net

working capital.

9

5.0 Analysis of the Project

Before making the Pro Forma Financial Statements, the calculations of the values of the

different components have been shown below.

1. Total initial investment required:

Machine No. of machines

(A)

Per unit machine cost

(B)

Total cost per model

(A × B)

Machine 1 15 units BDT 7,000,000 BDT 105,000,000

Machine 2 8 units BDT 7,000,000 BDT 56,000,000

Machine 3 7 units BDT 4,500,000 BDT 31,500,000

Total initial investment required BDT 192,500,000

Figure: Table 4

The values used in this table have been gathered from Table 1 in Segment 3.0 of the report. As

we can see, the total initial investment adds up to BDT 192,500,000.

2. Total units to be sold:

Machine Units produced

per hour per

machine (C)

No. of

Machines

(D)

Units

produced per

hour (C × D)

Hours

worked per

day (E)

Days per

year

(F)

Units per year

(C × D × E × F)

Machine 1 40 units 15 600 units 14 hours 300 2,520,000

Machine 2 40 units 8 320 units 14 hours 300 1,344,000

Machine 3 40 units 7 280 units 14 hours 300 1,176,000

Total number of units sold per year 5,040,000

Figure: Table 5

The values used in this table are from Table 1 and Table 3 in Segment 3.0 of the report. We

have assumed that the number of working days in a year for the company to be 300 days

10

adjusting for the holidays and vacations of the workers. We have found out the total number of

units sold in a year to be 5,040,000 units. Mr. Joshim Chowdhury has confirmed that Rainbow

Embroidery does not keep any finished goods left in their ending inventory at the end of each

year. This means that the total number of units produced in a year is the total number of units

sold in a year.

3. Total sales per year:

As mentioned in Table 3 in Segment 3.0 of the report, per unit selling price of the finished good

is BDT 24. Thus, using this value and the value of total number of units to be sold in a year from

Table 5 in the previous page (which is 5,040,000 units), we can calculate the “Total sales per

year”.

Thus, from the calculation that has been showed above, the total sales per year if Rainbow

Embroidery accepts the project is BDT 1,20,960,000.

4. Total variable cost per year:

As mentioned in Table 3 in Segment 3.0 of the report, per unit variable cost (confirmed by Mr.

Joshim Chowdhury) is BDT 12. This value and the value of the total number of units to be sold in

a year from Table 5 in the previous page can be used to calculate the “Total variable cost per

year”.

Calculation 1:

Total sales per year = Selling price per unit × Number of units sold per year

= BDT (24 × 5,040,000)

= BDT 1,20,960,000

Calculation 2:

Total variable cost per year = Variable cost per unit × Number of units sold per year

= BDT (12 × 5,040,000)

= BDT 60,480,000

11

Thus, from the calculation that has been shown above, the total variable cost per year from the

project will be BDT 60,480,000.

5. Total fixed cost per year:

As mentioned in Table 3 in Segment 3.0 of the report, the overhead rate per unit of output is

BDT 15. This overhead rate per unit consists of both fixed cost and variable cost. This value

along with the value of the total number of units to be sold in a year from Table 5 and the value

of total variable cost per year from the previous page can be used to calculate the “Total fixed

cost per year”.

Thus, from the calculation that has been shown above, the total fixed cost per year from the

project will be BDT 15,120,000.

6. Total depreciation expense from the machines per year:

To calculate the total depreciation from the machines per year, the values that will be required

are:

Cost of per unit machine (Table 1 from Segment 3.0 of the report)

Calculation 3:

Total overhead per year = Overhead rate per unit × Number of units sold per year

= BDT (15 × 5,040,000)

= BDT 75,600,000

Again,

Total overhead per year = Total variable cost per year + Total fixed cost per year

Or,

Total fixed cost per year = Total overhead per year - Total variable cost per year

= BDT (75,600,000 – 60,480,000)

= BDT 15,120,000

12

Number of machines to be bought (Table 1 from Segment 3.0 of the report)

Life of the machines (Table 2 from Segment 3.0 of the report)

Salvage value of the machines at the end of their lives (Table 2 from Segment 3.0 of the

report)

Depreciation will be calculated in the following way:

The depreciation expenses per year per machine calculated above can now be used to find the

total depreciation expense per year.

Machines Depreciation expense per

machine per year (G)

No. of machines

(H)

Depreciation expense

per year (G × H)

Machine 1 BDT 125,000 15 BDT 1,875,000

Machine 2 BDT 140,000 8 BDT 1,120,000

Machine 3 BDT 135,000 7 BDT 945,000

Total depreciation expense per year BDT 3,940,000

Figure: Table 6

7. Pro forma income statement

The values that have been identified in the previous calculations and tables will now be used to

construct a pro forma income statement for Rainbow Embroidery. As there are no changes in

the annual values of sales, total variable cost, total fixed cost and depreciation expenses

throughout the years, one income statement has been shown which is constant for Years 1 to

Calculation 4:

Depreciation expense for each machine = (Cost of machine – Salvage value) ÷ Life of machine

The depreciation expenses per year are:

For each unit of Machine 1 = BDT {(7,000,000 – 4,500,000) ÷ 20} = BDT 125,000

For each unit of Machine 2 = BDT {(7,000,000 – 4,200,000) ÷ 20} = BDT 140,000

For each unit of Machine 3 = BDT {(4,500,000 – 1,800,000) ÷ 20} = BDT 135,000

13

10 of the project. The corporate tax rate for non-publicly traded companies like Rainbow

Embroidery is 37.5% (Source: (Laila, 2012)).

A graph showing the various components in the income statement as a percentage of “Sales”

are given below.

Figure: Graph 1

50%

13% 3%

13%

21%

Variable Costs

Fixed Costs

Depreciation

Tax

Net Income

Rainbow Embroideries

Pro forma Income Statements (For the end of Years 1 to 10)

Years 1 to 10 (in BDT)

Sales 120,960,000

Less:

Variable Costs (60,480,000)

Fixed Costs (15,120,000)

Gross Profit 45,360,000

Less: Depreciation Expenses (3,940,000)

Earnings Before Taxes 41,420,000

Less: Tax (37.5%) (15,532,500)

Earnings After Taxes 25,887,500

14

8. Pro forma cash flow statement

To construct the pro forma cash flow statement, the first step is to calculate the “Operating

Cash Flow”. The operating cash flow will be constant throughout the years 1 to 10 and can be

found out using the following method.

This value of the operating cash flow per year can now be used to make the cash flow

statement. All the values in the Cash Flow statement below are in BDT.

Calculation 5:

Operating cash flow = Net Income + Depreciation expense

= BDT (25,887,500 + 3,940,000)

= BDT 29,827,500

Rainbow Embroideries

Pro forma Cash Flow Statements (For the end of Years 1 to 10)

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10

O.C

.F.

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,827,

500

Ca

p. S

pen

din

g

(192,50

0,000)

104,31

2,500

Pro

ject

C.F

.

(192,50

0,000)

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

29,82

7,500

134,14

0,000

15

The value of the “Capital Spending” in Year 0 is the value of the initial investment that has been

found out in Table 4 in the same segment of the report. The value of “Capital Spending” in Year

10 has been found out using the method shown below (for the numbers refer to Table 2 of

Segment 3.0 of the report).

Calculation 6:

Value of Capital Spending in Year 10 = Market value of all the machines – Tax on it

For 15 units of Machine 1, Total market value = 15 × BDT 6,100,000 = BDT 91,500,000

For 8 units of Machine 2, Total market value = 8 × BDT 6,100,000 = BDT 48,800,000

For 7 units of Machine 3, Total market value = 7 × BDT 3,800,000 = BDT 26,600,000

Total Market value of all the machine = BDT 91,500,000 + BDT 48,800,000 + BDT 26,600,000

= BDT 166,900,000

Tax on market value of all the machines = 0.375 × BDT 166,900,000

= BDT 62,587,500

Value of Capital Spending in Year 10 = BDT (166,900,000 – 62,587,500)

= BDT 104,312,500

16

9. Calculation of Net Present Value

Using the values of the “Project Cash Flow” from Years 1 to 10 shown in the Pro forma cash

flow statement, we will calculate the Net Present Value of the project. As mentioned in

Segment 3.0 of the report, the required rate of return from the project is 16%. The calculation

has been shown below.

As we can see from the calculation above, the value of NPV for the project at a return of 16% is

– BDT 24,690,974. Because the Net Present Value is negative, the project should not be

accepted.

Calculation 7:

= PV of Yr 0 + PV of Yr 1 + PV of Yr 2+ PV of Yr 3 + PV of Yr 4 + PV of Yr 5

+ PV of Yr 6 + PV of Yr 7 + PV of Yr 8 + PV of Yr 9 + PV of Yr 10

=

= BDT (– 192,500,000 + 25,713,362.1 + 22,166,691.4 + 19,109,216.8 + 16,473,462.8

+ 14,201,261 + 12,242,466.4 + 10,553,850.3 + 9,098,146.8 + 7,843,230

+ 30,407,338.6)

= – BDT 24,690,974

17

10. Calculation of Profitability Index

Using the values of the “Project Cash Flow” from Years 1 to 10, we will calculate the Profitability

Index of the project. The calculation has been shown below.

The value of the Profitability Index of the project is 0.8717. As it is less than 1, the project

should not be accepted.

Calculation 8:

= (PV of Yr 1 + PV of Yr 2+ PV of Yr 3 + PV of Yr 4 + PV of Yr 5 + PV of Yr 6 + PV of Yr 7

+ PV of Yr 8 + PV of Yr 9 + PV of Yr 10) ÷ PV of Yr 0

=

= (25,713,362.1 + 22,166,691.4 + 19,109,216.8 + 16,473,462.8 + 14,201,261 + 12,242,466.4

+ 10,553,850.3 + 9,098,146.8 + 7,843,230 + 30,407,338.6) ÷ 192,500,000

= 0.8717

18

11. Calculation of Internal Rate of Return

Using the values of the “Project Cash Flow” from Years 1 to 10, we will calculate the Internal

Rate of Return of the project. The calculation has been shown below.

Calculation 9:

At a discount rate of 13%,

PV of cash flows from Yr 1 to 10 = PV of Yr 1 + PV of Yr 2 + PV of Yr3 + PV of Yr 4

+ PV of Yr 5 + PV of Yr 6 + PV of Yr 7 + PV of Yr 8

+ PV of Yr 9 + PV of Yr 10

=

= BDT 192,580,524.3

At a discount rate of 14%,

PV of cash flows from Yr 1 to 10 = PV of Yr 1 + PV of Yr 2 + PV of Yr3 + PV of Yr 4

+ PV of Yr 5 + PV of Yr 6 + PV of Yr 7 + PV of Yr 8

+ PV of Yr 9 + PV of Yr 10

=

= BDT 183,721,340.6

19

From the calculation shown overleaf, we see that for the present values of cash flows from year

1 to year 10 are:

BDT 183,721,340.6 for a 14% discount rate

BDT 192,580,524.3 for a 13% discount rate

The initial investment on the whole project was BDT 192,500,000 and we see that this value of

the initial investment lies between the sum of present values at discount rates of 13% and 14%.

This means that the internal rate of return is between these two discount rates.

The internal rate of return for the project is determined below.

As the calculated IRR for the project (which is 13.0091%) is lower than the required rate of

return of 16%, the project should not be accepted.

Calculation 10:

For a change in the PV of BDT (192,580,524.3 – 183,721,340.6), there is a change in 1%

discount rate

Thus, for a change in PV of BDT (192,580,524.3 – 192,500,000), the change in discount rate is:

= (192,580,524.3 – 192,500,000) ÷ (192,580,524.3 – 183,721,340.6)

= 0.0091%

Therefore, IRR = 13% + 0.0091%

= 13.0091%

20

6.0 Recommendation

The findings from the analysis section of the report are repeated once again:

The Net Present Value is negative.

The Profitability Index is less than 1.

The Internal Rate of Return is less than the required rate of return.

All these findings compel us to recommend that Rainbow Embroidery should not accept this

project.

21

7.0 Bibliography

Laila, U. (2012, July). Tax Rates in Bangladesh. Retrieved June 18, 2013, from Blogspot:

http://taxratesinbangladesh.blogspot.com/

World Football News and Update. (2013, June 18). World Football News and Update. Retrieved

from Worldwide Football:

https://www.facebook.com/worldwide.football/posts/529842653746630