Question

(Capital Budgeting: Accept/Reject and Ranking Decisions)

            The Virginia Publications Distribution Company (VPD) is a medium sized firm with headquarters at their central warehouse and distribution center in Washington D.C. and their forms production facilities at a plant in Annandale, Virginia. The company's primary business consists of the design and printing of forms used by the Department of Defense (DOD) although they do have some minor contracts with a few other government agencies. In addition to the actual production of the forms, they also have a contract to serve as the warehouse and distribution center for all DOD forms used both in Washington D.C. and at the various military bases throughout the world.

            The company is divided into two divisions to reflect the separate contracts for forms printing as distinct from forms distribution. Although this natural separation has greatly assisted the accounting function when preparing contract bids, it has also led to some rivalry between the two divisions in competing for the limited amount of funds available each year for capital investment. In general, the capital budgeting decisions in prior years were based on the final decision of the CEO after hearing arguments, often very subjective, from the two division vice presidents. The new procedure instituted this year was to relegate this decision to a capital budgeting staff headed by the vice president for finance. This staff was to rely primarily on objective criteria in reaching their decision and the subjective arguments would be left to the division vice presidents when/if they chose to appeal the decision to the CEO.

            In preparing to conduct their analysis, the capital budgeting staff first developed their estimate of the marginal cost of capital (MCC) for the firm. It was a relatively simple task to arrive at the cost of capital using a weighted average of the costs of debt and equity as derived from observed stock and bond market information along with additional input from the investment banking firm of Keating and Trump. The final estimate suggested a cost of capital of 10 percent.

            The two division vice presidents have forwarded five capital budgeting projects for evaluation and possible funding. The Printing Division submitted a proposal (Project A) to upgrade the loading and unloading facilities at both company locations to increase the efficiency of transporting finished forms from the printing to the storage and distribution warehouse. They also submitted a proposal (Project B) to replace most of the printing and paper cutting machinery with the latest models. Although this equipment is fairly expensive, the primary advantage is that all of the layout work, cutting, and packaging can be controlled by one person from a single location. In addition to the greater efficiency in the use of materials, this computerized system would allow the current labor force to be reduced by 15 people.

            The Distribution Division proposed three projects. The first proposal (Project C) involved an upgrade to the loading and transportation facilities and was essentially equivalent in terms of accomplished goals to Project A. Thus, the staff immediately concluded that Project A and Project C should be considered as mutually exclusive assets for the purpose of this evaluation. Finally, Projects D and E were proposed as alternative approaches to building a major addition to the distribution center. This would allow the company to own a single in-house facility and thereby discontinue leasing space in a privately owned building directly across the street from the center.

            The cash flow projections for each of these five proposed projects are shown in Exhibit 1. Project B has been classified by the staff as an independent project for purposes of evaluation since it is not impacted by the acceptance or rejection of any of the other projects.

Exhibit 1

Projected Cash Flows

Year	Project A	Project B	Project C	Project D	Project E
0	($1,750,000)	($1,800,000)	($1,750,000)	($2,500,000)	($2,700,000)
1	318,633	458,154	900,000	431,700	483,000
2	318,633	458,154	675,000	431,700	483,000
3	318,633	458,154	450,000	431,700	483,000
4	318,633	458,154	275,000	431,700	483,000
5	318,633	458,154		431,700	483,000
6	318,633			431,700	483,000
7	318,633			431,700	483,000
8	318,633			431,700	483,000
9	318,633			431,700	483,000
10	318,633			431,700	483,000

               Assume that you are the staff members responsible for this capital budgeting decision. Prepare a report showing all of the capital budgeting decision criteria that you feel are important and recommend a solution to the overall capital budgeting decision for the firm. Use graphs where important to demonstrate the reasons for your conclusions. To assist you in your analysis, your decision should include two distinct steps. First, do an accept/reject decision on each asset. Second, address any capital rationing and/or mutually exclusive problems.

Answer 1

Answer ) Capital budgeting has many methods of calculation , out of those NPV is consider as the best one.

NPV = PV ( cash Inflow ) - Cash out flow,

Project with higher NPV would be preferred .

The value of NPV for all 5 projects are calculated below

	Cost of capital	10%
Year	Project A		Project B		Project C		Project D		Project E
	Cash flow	PV(cash flow)	Cash flow	PV(cash flow)	Cash flow	PV(cash flow)	Cash flow	PV(cash flow)	Cash flow	PV(cash flow)
0	($1,750,000)	($1,750,000)	($1,800,000)	($1,800,000)	($1,750,000)	($1,750,000)	($2,500,000)	($2,500,000)	($2,700,000)	($2,700,000)
1	$318,633	$289,666	$458,154	$416,504	$900,000	$818,182	$431,700	$392,455	$483,000	$439,091
2	$318,633	$263,333	$458,154	$378,640	$675,000	$557,851	$431,700	$356,777	$483,000	$399,174
3	$318,633	$239,394	$458,154	$344,218	$450,000	$338,092	$431,700	$324,343	$483,000	$362,885
4	$318,633	$217,631	$458,154	$312,925	$275,000	$187,829	$431,700	$294,857	$483,000	$329,895
5	$318,633	$197,846	$458,154	$284,478			$431,700	$268,052	$483,000	$299,905
6	$318,633	$179,860					$431,700	$243,683	$483,000	$272,641
7	$318,633	$163,509					$431,700	$221,530	$483,000	$247,855
8	$318,633	$148,645					$431,700	$201,391	$483,000	$225,323
9	$318,633	$135,131					$431,700	$183,083	$483,000	$204,839
10	$318,633	$122,847					$431,700	$166,439	$483,000	$186,217
	NPV	$3,707,862		$3,536,764		$3,651,953		$5,152,610		$5,667,826

Rank	Projects	NPV
1	E	$5,667,826
2	D	$5,152,610
3	A	$3,707,862
4	C	$3,651,953
5	B	$3,536,764

It clearly indicate that without use of capital rationing and/or mutually exclusive concept , project E should be considered as the most suitable one , as shown in bar graph below for better understanding .

Part 2)

Use concept of mutually exclusive problems,

• Project A and Project C should be considered as mutually exclusive assets for the purpose of this evaluation.
• Projects D and E were proposed as alternative approaches to building a major addition to the distribution center.

As per above two highlighted point , it is clear that either A or C and Either D or E can be selected as per used concept .The project with higher NPV will be selected.

So, new ranking of project will be,

Rank	Projects	NPV	Status
1	E	$5,667,826	Accept
	D	$5,152,610	Reject
2	A	$3,707,862	Accept
	C	$3,651,953	Reject
3	B	$3,536,764

The below Bar Graph indicate the rejected project in red colour.