HOLA-KOLA – The Capital Budgeting Decision Case Solution
Other relevant costs that will be incorporated in the valuation include working capital and machine purchasing cost. The purchase of machine will be the initial outlay. The inflation rate might affect the cash flows and as it will increase the expense for the company. However, the company might also increase the prices, but this should be limited or else the sales volume would be reduced. Moreover, there is a threat from the competitors if they counter the company’s new product with potential new substitute product at the same price. These risks should be considered while making decision.
The financial valuation has been made using the discounted cash flow model. Project Evaluation will be based on the NPV and IRR analysis, using the cash flows. The Cash flows has been estimated using the data provided in the case. First of all, the project net cash flow or after tax Profit/Return has been estimated, which will then be used for NPV analysis. All the calculations have been made using the case data. Manufacturing cost includes raw material, labor, and energy cost. Depreciation is calculated at the rate of 20% at machine cost less residual value.
General, Selling, and Admin cost was given while Overhead cost is taken as 1% of sales. The after tax profit has been calculated after deducting the tax expense. In the DCF model, depreciation is added back because it is a non-cash item. Working capital has been estimated using the case instructions, see excel. The changes in working capital have been incorporated in the model. In the first year, working capital has been deducted since it is a cash outflow. At the end of the fifth year, which is assumed to be the last year and the project will be ended, this working capital is added back since it is removed from the project.
Opportunity cost and cannibalization cost is also deducted. The residual value of the machine will be added, as it will be sold at this value at the end of the fifth year. Net cash flows have been calculated and are then discounted using the cost of capital given, which is 18.20%. The Net Present Value is estimated to be -1346245 pesos; while IRR is calculated to be 17%. With such projected results, the project looks unfavorable.
The projections have also been made using two other different scenarios and the results suggest that scenario 2 is the best option. The results are compared in the next part. The company might have break-even if it is able to sell 7403320 units per year.
As per the comparison, the best case is the scenario 2. In this scenario, the company has assumed an increased sales price growth rate and Material, Energy, and Labor expense growth by 5%. As a result, it is estimated that the sales will be lowered by 2%. The result however, is highly feasible. The company will have Positive Net Present Value and the internal rate of return will be 21%. It is a recommended option.
Bebida Sol has been considering an expansion project through new product launch, Hola-Kola, a calorie free low-priced carbonated soft drink. The market study confirms the feasibility of the product. A financial evaluation has been made, which confers that the project is not feasible with the base case assumptions. The company should go with an increase in the sales price while expecting increment in expenses at the same rate, which is 5%. It will reduce the sales volume by 2%, but the overall profitability ensures a positive Net Present Value and high internal rate of return. It is recommended that the company should adopt the option 3 (scenario 2) or else drop this project, as it will otherwise generate loss for the company……………………
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