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Capital Budgeting


Question 4 (12 marks) Phonic Solutions PLC is considering creating a new division, which will require an investment in computer & telecommunications equipment of $10 million. The company has a cost of capital of 12%. The sales department has forecast sales for each of the next five years as follows: Year 1 $4 million Year 2 $6 million Year 3 $8 million Year 4 $6 million Year 5 $4 million Operations staff have predicted the cost of sales as 30% of revenue. Rent and office expenses are $300,000 each year. Selling and administration salaries will be $400,000 in the first year increasing each year by 5%. Repairs & maintenance will be $100,000 in each of years 1 and 2, $200,000 in each of years 3 and 4, and $300,000 in year 5. The company depreciates its equipment over 4 years. a. Produce a i. Profit budget for each of the five years, showing both gross profit and operating profit; (2 MARKS) ii. Cash flow for each of the five years (2 MARKS), and iii. Apply a discounted cash flow technique and use this to recommend whether the new division and capital investment should proceed (2 MARKS). b. What does theory tell us about the strengths and limitations of budgeting and the discounted cash flow technique? (6 MARKS)