Greetings Inc.: Capital Budgeting Harvard Case Solution & Analysis

Analysis

Net Present Value (NPV)

The net present value technique uses the estimated future cash flows that are expected to occur if the decision to invest in a particular project is made. Meanwhile, the net present value technique also incorporates the cost saving or revenues generated by the project during the use full life of the project. Further, the net present value techniques uses the risk adjusted discount rate that will be used to discount the future cash flows of the project. However, the investment project under consideration requires an initial investment of $800,000 in equipment such as computers and printers which have a use full life of 5 years, meanwhile, the project will require immediate additional investment for the purchase of blank CD and ink that will be used to print the CD covers and this will cost $100,000. Further, the project will generate cost savings of $175,000 for Wall Décor division, additionally; the project will increase the sales revenues of its store sales, which would be $100,000 per year for the period of five years. In addition to this the estimated risk adjusted discount rate of 12% has been used for discounting the net cash flows of the project.

However, the net present value technique used for the evaluation of investment proposal gives a present value of $119,685/ which means that the proposed investment project will increase the worth of Greetings Inc. store by the present value generated by this project. Meanwhile, the evaluation of the investment project will not be reasonable on single evaluation criteria of net present value method, therefore other evaluation techniques have also been used for the evaluation of proposed investment project as discussed below.

Internal Rate of Return (IRR)

The internal rate of return calculates the maximum percentage of return that a particular project will generate on the invested funds. However, the internal rate of return for the proposed project has been calculated at 17.12%, which means that the proposed investment project will generate $0.1712 for every dollar invested in this project. Meanwhile, Greeting Inc.’s cost of using the fund is 12%, which is quite lower than the returns generated by the proposed investment project. Therefore, the investment in this project will increase the overall value of Greetings Inc.

Discounted Payback Period

Additionally, the discounted payback period measures the time period during which the initial investment in a project will be recovered. Meanwhile, the discounted cash flows are used in this method which also incorporates the time value of money in the calculation of the discounted payback period. However, based on the discounted cash flows of a proposed investment project the estimated payback period of this project is 4.65 years. Further, the total period of the project is 5 years and comparison of payback period of 4.65 years and total life of the project reveals the recovery of the initial investment will be made in the mid of last year. Therefore, the longer recovery period will probably affect the cash flows, because the future is uncertain and due to this uncertainty of cash flows their recovery might be affected. Hence, the long recovery period of 4.65 years decreases the attractiveness of this project.

Sensitivity Analysis

Additionally, since the cash flows associated with this project are based on the estimates, hence the reasonableness of these cash flows and their timing of occurrence should be evaluated. Because the timing and of the inflow and outflow of cash will affect the attractiveness of this project, therefore, it is equally important to assure that the timing of cash flows has been reasonably estimated.

Cost of Equipment

Since the cost of equipment is required to be paid at the beginning of the period, hence, its timing is assured and will not be changed. Further, the cash outflow depends on the market value of equipment used on the actual date when the equipment are purchased. Meanwhile, the sensitivity analysis shows that the net present value of the project is more sensitive to the change in cost of equipment required, because only 15% increase in the cost of equipment will bring the net present value of the project to zero.

Cost Savings and Revenue Generation

However, since the net present value of the project depends on the cash inflows or savings generated by the project, which will occur during the life of the project, hence, the volatility of the cost savings and revenues generated by the project should also be considered while making the final decision of investment into a proposed business. Meanwhile, the net present value of the project is more sensitive to the cost savings that will be generated by the project than to the revenues that will be generated.................

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