Capital Budgeting Techniques For Printer Replacement Decision

Introduction to CQU Printers and Printer Replacement Decision

CQU Printers is a printing firm and hence it holds printers as its assets. With the old printer the company is facing some issues regarding the quality of printing and its costs inefficiency hence it is considering the decision of replacing it with another printer. There are two options available with the firm to invest in for the purpose of replacing the old printer. The firm can either purchase new printer A or printer B. To evaluate both the proposals different capital investment appraisal techniques will be applied. The inflow from sale of old printer will be adjusted from the initial investment made in the purchase of new printer.

Capital budgeting techniques are those financial tools that helps the managers in their decision making regarding the capital investments to be made to earn maximum profitability with minimum deployment of financial and non-financial resources. Whenever, the choice between the two possible alternative investments is available, the firm must rank those alternative plans on various basis such as Net present value, payback period, internal rate of return etc.

Determination of initial investment in both the cases of replacement printers:

Initial investment involves the outflow of cash in year 0 for the acquisition and installation of the assets in the business of the firm. In this case the initial investment will be calculated on the net basis by adjusting the amount of cash inflow from the disposal of old printer. The tax on capital gain on the sale of old printer is ignored as per the requirement of case question.

The initial investment in the case of Printer A will be $ 450,000 (Working Note: 2)

The initial investment in the case of Printer A will be $ 240,000 (Working Note: 3) 

Working Notes:

Old printer details

Old Printer	Amounts
Cost	$ 4,00,000.00
Residual value at the end of 5th year	$ 1,50,000.00
Useful Life	5 years
Depreciation as per SLM	$     50,000.00
Carrying amount at the end of 3rd Year	$ 2,50,000.00
Recoverable price at the end of 3rd year	$ 4,20,000.00
Capital Gain	$ 1,70,000.00

Initial investment

New Printer A
Cost	$ 8,30,000.00
Installation cost	$     40,000.00
Total Cost	$ 8,70,000.00
Less: Inflow from Old printer	$ 4,20,000.00
Net capital investment	$ 4,50,000.00
Cost of asset	$ 8,70,000.00
Residual value at the end of 5th year	$ 4,00,000.00
Useful Life	5 years
Depreciation as per SLM	$ 1,65,300.00

Depreciation = Total cost of asset- Residual value

                                        Useful life

                       = 870000-43500

                                  5

                       = $ 165300 

New Printer B
Cost	$ 6,40,000.00
Installation cost	$     20,000.00
Total Cost	$ 6,60,000.00
Less: Inflow from Old printer	$ 4,20,000.00
Net capital investment	$ 2,40,000.00
Cost of asset	$ 6,60,000.00
Residual value at the end of 5th year	$ 3,30,000.00
Useful Life	5 years
Depreciation as per SLM	$ 1,25,400.00

Depreciation= 660000-33000

                                 5

                      = $125400 

Determination of operating cash flows of the firm of replacement printers: 

Operating cash flows are the cash movement in and out of business due to the operating activities of business of the firm. The incremental cash flows will be determined in the present case as replacement decision has to be made in regards to new printer in place of new printers.

Incremental cash flows= Cash flows of printer A minus Cash flows of old printer

Note= Cash flows are to be taken as net of depreciation.

Capital Budgeting Techniques for Evaluating Printer Replacement Options

Printer A 

Year	Incremental Cash Flows( v-iv)	Tax @30%	Cash flows after tax	Incremental Depreciation (i-ii)	Total cash flows
0					$    -90,400.00
1	$                                           14,700.00	$    4,410.00	$     10,290.00	$ 1,15,300.00	$  1,25,590.00
2	$                                           34,700.00	$ 10,410.00	$     24,290.00	$ 1,15,300.00	$  1,39,590.00
3	$                                           64,700.00	$ 19,410.00	$     45,290.00	$ 1,15,300.00	$  1,60,590.00
4	$                                           94,700.00	$ 28,410.00	$     66,290.00	$ 1,15,300.00	$  1,81,590.00
5	$                                       1,34,700.00	$ 40,410.00	$     94,290.00	$ 1,15,300.00	$  2,09,590.00
Net operating cash flows					$  7,26,550.00

Printer B 

Year		Incremental Cash Flows (vi-iv)	Tax @30%	Cash flows after tax	Incremental Depreciation (iii-i)	Total cash flows
0						$                    –
1		$     14,600.00	$         4,380.00	$     10,220.00	$     75,400.00	$     85,620.00
2		$     14,600.00	$         4,380.00	$     10,220.00	$     75,400.00	$     85,620.00
3		$     14,600.00	$         4,380.00	$     10,220.00	$     75,400.00	$     85,620.00
4		$     14,600.00	$         4,380.00	$     10,220.00	$     75,400.00	$     85,620.00
5		$     14,600.00	$         4,380.00	$     10,220.00	$     75,400.00	$     85,620.00
Net operating cash flows						$ 4,28,100.00

Workings: 

Changes in cash balance due to operating activities at year 0: 

Decrease in current assets
Inventories	$       20,000.00
Increase in current liabilities
Accounts Payable	$       35,000.00
Increase in current assets
Cash	$     -25,400.00
Accounts Receivables	$ -1,20,000.00
Decrease in current liabilities	$                      –
operating cash flows in year 0	$     -90,400.00

Old Printer 

Year	EBDT (A)	Depreciation (B)(i)	EBT (A-B) (iv)
1	$ 1,20,000.00	$ 50,000.00	$     70,000.00
2	$ 1,20,000.00	$ 50,000.00	$     70,000.00
3	$ 1,20,000.00	$ 50,000.00	$     70,000.00
4	$ 1,20,000.00	$ 50,000.00	$     70,000.00
5	$ 1,20,000.00	$ 50,000.00	$     70,000.00

New Printer

Year	EBDT (A)	Depreciation (B) (ii)	EBT (A-B) (v)
1	$ 2,50,000.00	$   1,65,300.00	$     84,700.00
2	$ 2,70,000.00	$   1,65,300.00	$ 1,04,700.00
3	$ 3,00,000.00	$   1,65,300.00	$ 1,34,700.00
4	$ 3,30,000.00	$   1,65,300.00	$ 1,64,700.00
5	$ 3,70,000.00	$   1,65,300.00	$ 2,04,700.00

New Printer B 

Year	EBDT (A)	Depreciation (B)(iii)	EBT (A-B) (vi)
1	$ 2,10,000.00	$ 1,25,400.00	$ 84,600.00
2	$ 2,10,000.00	$ 1,25,400.00	$ 84,600.00
3	$ 2,10,000.00	$ 1,25,400.00	$ 84,600.00
4	$ 2,10,000.00	$ 1,25,400.00	$ 84,600.00
5	$ 2,10,000.00	$ 1,25,400.00	$ 84,600.00

Terminal cash flows are those cash flows that occurs in the last year of asset’s useful life and these are different from normal operating cash flows of business. In the last year the company will be selling the Printer A at $ 400000 or if Printer B is chosen, then it will be sold at $330000. No capital gain tax is imposed on such transaction as per the requirements of case.

Particular	PRINTER A	PRINTER B
Salvage value	$                    4,00,000.00	$      3,30,000.00
Book Value	$                        43,500.00	$          33,000.00
Capital Gain	$                    3,56,500.00	$      2,97,000.00

 Part B

Cash flow stream of any asset is the estimated values possible cash flows during the asset’s useful life. It included both inflow and outflows of cash associated with the asset. All the cash flows related to the printer possessed by the firm will be covered while determining its cash flow stream from its acquisition till the end of its useful life (Dyson & Berry, 2014). Hence it will include the net initial investment, operating cash flows and the terminal cash flows from the replacement printers.

Printer A

Year	Initial Investment	Changes in cash balance	Incremental CFATS	Terminal Cash flows	Total cash flows	PVF	Present value of cash flows
0	$          -4,50,000.00	$                         -90,400.00			$ -5,40,400.00	1.000	$ -5,40,400.00
1			$              1,25,590.00		$   1,25,590.00	0.877	$   1,10,166.67
2			$              1,39,590.00		$   1,39,590.00	0.769	$   1,07,409.97
3			$              1,60,590.00		$   1,60,590.00	0.675	$   1,08,393.68
4			$              1,81,590.00		$   1,81,590.00	0.592	$   1,07,515.86
5			$              2,09,590.00	$                 3,56,500.00	$   5,66,090.00	0.519	$   2,94,009.41

 Printer B

Year	Initial Investment	Incremental CFATS	Terminal Cash flow	Total cash flows	PVF	PV of cash flows
0	$          -2,40,000.00	$                                          –		$               -2,40,000.00	1.000	$ -2,40,000.00
1		$                           85,620.00		$                    85,620.00	0.877	$       75,105.26
2		$                           85,620.00		$                    85,620.00	0.769	$       65,881.81
3		$                           85,620.00		$                    85,620.00	0.675	$       57,791.06
4		$                           85,620.00		$                    85,620.00	0.592	$       50,693.91
5		$                           85,620.00	$              2,97,000.00	$                 3,82,620.00	0.519	$   1,98,720.84

Whenever in the question discounting rate is give, discounted payback period is determined as it gives more reliable results than the normal payback period. Hence, in the present case discounted payback period will be calculated using the discounting rate of return of 14%.

Payback period is the period in which the project is expected to recover its initial investment by generating returns in the form of cash inflows (Dayananda, 2002). The project with lower payback period is always preferred over the project which has higher payback period (Danielson & Scott, 2006).

Printer A

Year	Cash flows	PVF @ 14%	PV of Cash Flows	Cumulative cash flows
0	$ -5,40,400.00	1.000	$             -5,40,400.00	$ -5,40,400.00
1	$   1,25,590.00	0.877	$               1,10,166.67	$ -4,30,233.33
2	$   1,39,590.00	0.769	$               1,07,409.97	$ -3,22,823.36
3	$   1,60,590.00	0.675	$               1,08,393.68	$ -2,14,429.69
4	$   1,81,590.00	0.592	$               1,07,515.86	$ -1,06,913.83
5	$   2,09,590.00	0.519	$               1,08,854.48	$         1,940.65
				3.018 Years

Printer B

Year	Cash flows	PVF	PV of Cash Flows	Cumulative cash flows
0	$ -2,40,000.00	1.000	$             -2,40,000.00	$ -2,40,000.00
1	$       85,620.00	0.877	$                  75,105.26	$ -1,64,894.74
2	$       85,620.00	0.769	$                  65,881.81	$     -99,012.93
3	$       85,620.00	0.675	$                  57,791.06	$     -41,221.87
4	$       85,620.00	0.592	$                  50,693.91	$         9,472.05
5	$       85,620.00	0.519	$               1,52,445.09	$   1,61,917.14
				2.19 Years

Conclusion: As per the payback period technique of capital investment, Printer B must be accepted as it has lower payback period. Hence, it is capable of recovering its capital investment earlier than that of Printer A.

Net present value is the most common capital budgeting technique and it gives the most reliable results ((Truong, Partington& Peat, 2008). The application of this technique is the simplest among all the capital investment appraisal techniques. Net present value of any investment is the sum total of present values of all the cash flows associated with the asset. The present value of outflows of cash is deducted from the present value of cash inflows. The project with higher NPV is preferred over project with lower one as higher NPV shows high profitability of the project (Alkaraan & Northcott, 2006).

PRINTER A
Year	Cash flows	PVF	PV of Cash Flows
0	$ -5,40,400.00	1	$             -5,40,400.00
1	$   1,25,590.00	0.877	$               1,10,166.67
2	$   1,39,590.00	0.769	$               1,07,409.97
3	$   1,60,590.00	0.675	$               1,08,393.68
4	$   1,81,590.00	0.592	$               1,07,515.86
5	$   5,66,090.00	0.519	$               2,94,009.41
NPV			$               1,87,095.58
PRINTER B
Year	Cash flows	PVF	PV of Cash Flows
0	$ -2,40,000.00	1.000	$             -2,40,000.00
1	$       85,620.00	0.877	$                  75,105.26
2	$       85,620.00	0.769	$                  65,881.81
3	$       85,620.00	0.675	$                  57,791.06
4	$       85,620.00	0.592	$                  50,693.91
5	$   3,82,620.00	0.519	$               1,98,720.84
NPV			$ 208192.89

Calculation of Initial Investment in Replacement Printers

Conclusion: In this case Printer B has higher NPV and hence it must be selected for the replacement purpose.

Internal rate of return of any project is the rate of return at which the NPV of that project is zero (Röhrich, 2007). The project must be accepted if its IRR is higher than the required rate of return. However, when the firm has alternative capital investment plans it must select the one with higher IRR.

PRINTER A
Year	Cash flows
0	$ -5,40,400.00
1	$   1,25,590.00
2	$   1,39,590.00
3	$   1,60,590.00
4	$   1,81,590.00
5	$   5,66,090.00
IRR	24.40%

PRINTER B
Year	Cash flows
0	$ -2,40,000.00
1	$       85,620.00
2	$       85,620.00
3	$       85,620.00
4	$       85,620.00
5	$   3,82,620.00
IRR	37.93%

Conclusion: In this case Printer B has higher NPV and hence it must be selected over Printer A.

The Net present values and internal rate of return of both the investment option is plotted on the graph as graphical representation of any data or information makes it easier to understand and interpret it.

The net present value of an asset is the aggregate of present values of all the estimated cash flows. Higher the NPV better is the capital investment decision (Bierman & Smidt, 2012). In this case printer A has lower NPV than that of printer B. Hence investment in printer B is more profitable (Bennouna, Meredith & Marchant, 2010).

IRR must be more than the cost of capital of the capital investment and in this case the cost of capital is 14%. But printer B has higher IRR than printer A (Drake, 2006). So, both the techniques of capital investment appraisal are recommending selection of printer B as the replacement of old printer. There is no conflict in the results of both the techniques. As per the results of both the techniques Printer B is ranked first and it must be selected by the firm to bring the desired improvements in the business operations. 

The quantum of available funds influences the investments decisions of the company. If the company has unlimited funds its capital investment decision becomes simplified as projects with higher return potential will be chosen for the investment (Graham & Harvey, 2002). In such case the company can invest in the project which entails higher profitability irrespective of the funds required to be invested in such asset as there is no lack of funds with the company. Therefore, the firm can invest in both the new printers as it does not have any scarcity of funds and bringing both the Printers will enhance the operational capacity of firm and thereby it will provide higher returns to the business.

It is the situation where the firm has limited amount of funds available with it for the capital investments but the requirement of funds is more than the availability of funds. In such a case the company will have to rank the potential projects plans on the basis of their respective NPVs or IRRs (Brijlal, 2008).  Then it will have to select one of the projects which has higher rank as it will offer higher returns. The ranking is also sometimes done on the basis of risks rates (Kahraman, 2001). Therefore on the basis of NPV and IRR printer B has a higher rank and it must be accepted. 

Determination of Operating Cash Flows for Replacement Printers

As a general rule of finance, to generate higher returns on the investments, higher risk must be accepted for that plan. Investment providing fluctuating returns can offer higher returns than the investment with uniform returns. However, at the same time higher risk is involved in those investments due to uncertainty of cash flows (Gitman, Joehnk, Smart & Juchau, 2015). But there is lesser risk in the investments which have an approach of providing constant returns as returns are already pre-determined in such cases. The cash flows associated with printer A are fluctuating and hence there is higher risk involved in it due to higher return potential.  In the project B the expected returns associated with printer are uniform and therefore there is less risk involved due to less return potential of the printer. If the company has a capacity of bearing higher risk it must select the investment proposal in printer A as it will offer higher return due to higher risk involved in it with the uncertainties of quantum of cash flows (Herbst, 2003). But if the company cannot tolerate higher risk then it must accept the investment in printer B as it will have uniform cash flows (Gitman, Juchau & Flanagan, 2015).

Conclusion:

From the above study, it is clear that capital investments are generally one time investment which involves deployment huge amount of financial resources. Hence such investments requires critical decision making before selecting any investment or project plans. These investment plans entails returns and risks and such factors must be typically analysed using the capital budgeting techniques. In the present case, it is observed that Investment in Printer B would be more beneficial for the firm than investment in Printer A. Also, the replacement decision of old printer with a new one is also proved to be appropriate from the above analysis.

References: 

Alkaraan, F., & Northcott, D. (2006). Strategic capital investment decision-making: A role for emergent analysis tools?: A study of practice in large UK manufacturing companies. The British Accounting Review, 38(2), 149-173.

Bennouna, K., Meredith, G. G., &Marchant, T. (2010). Improved capital budgeting decision making: evidence from Canada. Management decision, 48(2), 225-247.

BiermanJr, H., &Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.

Brijlal, P. (2008). The use of capital budgeting techniques in businesses: A perspective from the Western Cape.

Danielson, M. G., & Scott, J. A. (2006). The capital budgeting decisions of small businesses. Journal of Applied Finance, 16(2), 45.

Dayananda, D. (2002). Capital budgeting: financial appraisal of investment projects. Cambridge University Press.

Drake, P. P. Capital budgeting techniques. Online (datum poslednírevize: 29.6. 2006): www. fau. edu/~ ppeter/fin3403/module6/capbudtech. pdf.

Dyson, R. G., & Berry, R. H. (2014). Capital investment appraisal. Developments in Operational Research: Frontiers of Operational Research and Applied Systems Analysis, 59.

Gitman, L. J., Joehnk, M. D., Smart, S., & Juchau, R. H. (2015). Fundamentals of investing. Pearson Higher Education AU.

Gitman, L. J., Juchau, R., & Flanagan, J. (2015). Principles of managerial finance. Pearson Higher Education AU.

Graham, J., & Harvey, C. (2002). How do CFOs make capital budgeting and capital structure decisions?. Journal of applied corporate finance, 15(1), 8-23.

Herbst, A. F. (2003). Capital asset investment: strategy, tactics and tools. John Wiley & Sons.

Kahraman, C. (2001). Capital budgeting techniques using discounted fuzzy cash flows. Soft Computing for Risk Evaluation and Management, 375-396.

Röhrich, M. (2007). Fundamentals of investment appraisal: an illustration based on a case study. Oldenbourg Verlag.

Truong, G., Partington, G., & Peat, M. (2008). Cost-of-capital estimation and capital-budgeting practice in Australia. Australian journal of management, 33(1), 95-121.