NEUROPOWER Project Analysis On Capital Budgeting And Decision Making

Question

Task: Assume that you are an adviser at LATECH Ltd, which is analysing the introduction of a new game  console named NEUROPOWER. This system can be connected with human brain functions, and is still very much controversial for claimed but yet to be confirmed adverse impacts on human behaviour after prolonged application. Health conscious groups are also lobbying against introduction of such games with probable detrimental effects.

The Project Manager of LATECH Ltd needs a detailed analysis of this exciting NEUROPOWER project. She comes into your office, drops a consultant’s report on your desk, and complains, 'We paid these consultants $1 million for this report, and I am not sure their financial analysis makes sense, though their estimations seem to be correct. Before we spend $60 million on buying new equipment needed for this project, look it over and give me your opinion.' You open the report and find the following information and estimates:

The project will continue for the next seven years, and by that time more reliable information on possible adverse impacts of using NEUROPOWER will be available. It is projected that equipment will have an economic life of 10 years. After buying the equipment, it requires renovation of the production bay at LATECH Ltd and installation of the equipment at a total cost of $2 million. These renovation and installation costs are to be considered as capital expenditures. A staff training cost of $200,000 is to be incurred initially at the start of the project.

The equipment will be procured from Germany and LATECH Ltd has to pay 8% import duty on purchase price, whereas the supplier will pay transportation costs of $90,000. These property, plant and equipment (PPE) would be depreciated over their useful life of 10 years using a tax allowable straight line rate of 10%. However, the company is planning to sell the equipment at the end of the project for an estimated price of $12 million.

Consultants estimate that 96,000 NEUROPOWER consoles can be sold in the first year with an expected increase by 25% in each year for the next two years; afterwards, sales are expected to decrease by 20% in each year until the end of the project, due to a number of actions by the competitors in the market. Annual fixed operating cost, excluding depreciation, will be $1 million. Variable operating costs will be 50% of sales. Beginning selling price per console will be $500, which will be dropped by 10% in the fourth year for the rest of the project life.

Existing facilities to be used for the NEUROPOWER project are coming from another production line that earns net $21,000 per month. That production line will be discontinued on the commencement of the NEUROPOWER project. For the duration of the project, LATECH is also planning to take the service of a market analyst at a cost of $9,000 per month.

It is also estimated that the new production line will require an initial increase in investment for $970,000 in stock (inventories) and $910,000 in debtors (accounts receivable) that are offset by an increase in creditors of $480,000 (accounts payable). There will be no further investment in net working capital (NWC) until its final recovery at the end of project life.

The company uses required rate of return considering its weighted average cost of capital (WACC) that varied from 16% to 22% in recent times. The analyst is confused about the rate to be effective for the project; however, she has decided to use 16% required rate to evaluate this project. Corporate tax rate is 30%. The required discounted payback period is five years.

The Project Manager hesitates to take the final decision because of unexpected growth in the game industry, with technological advancement in different directions. As an alternative, LATECH has an offer to introduce an upgraded version of a safe traditional game console, the IQFORCE. Initial total investment for this IQFORCE project would be the same as the NEUROPOWER project and projected net future cash flows (after all adjustments) would be as follows:

• Year 1: $30,400,000; Year 2: $29,200,000; Year 3: $19,700,000;
• Year 4: $17,500,000; Year 5: $15,200,000; Year 6: $10,000,000;

Before taking the final decision in the upcoming meeting, the Project Manager of LATECH Ltd requires a clear explanation of all relevant issues relating to the NEUROPOWER project. Particularly, a formal report is enquired by the Project Manager to include a detailed analysis of cash flows and explanations of results of capital budgeting methods that are commonly used in evaluating projects. Furthermore, in a separate section in the report, the Project Manager is interested in reviewing a detailed comparison between the NEUROPOWER and IQFORCE projects, with regard to the results of applicable capital budgeting methods using both 16% and 22% required rates, crossover rate and all relevant factors that can assist in taking the final decision.

Your assignment will require the following:
Using an Excel spreadsheet, prepare a full analysis to be presented to the Project Manager of LATECH Ltd to assist in evaluating whether either project should be started or not. Your analysis should include the following:

• table of cash flows (show all digits, do not convert amounts to $ in million or thousand)
• use of Excel formulae where appropriate
• a written report (1500 words, +/- 10%) outlining your recommendation as to whether LATECH Ltd should proceed with either project. Justify your recommendations using quantitative and qualitative issues, and your analysis of probable risks and benefits relating to the project. Comparison statement is to be presented in a separate section in the report.

Answer

Executive Summary
The report is prepared to evaluate the financial feasibility of proposed projects involving introducing of gaming consoles by LATECH LTD. As a part of NEUROPOWER project analysis, application of different capital budgeting techniques is made and it has been found that it is not feasible to undertake the project NEUROPOWER as it will not be under the acceptable parameters of the company. The required rate of return and the payback period in the proposed project are not achieved well. Rather, the company must go with the introduction of IQFORCE which is has the capacity to generate sufficient returns and also the required rate of return will be achieved in this case. Further the payback period of the project will be lesser than the required payback period. Furthermore, the current NEUROPOWER project analysis will involve identification of crossover rate which will be 13.578%.

Introduction
The present report on NEUROPOWER project analysis examines the feasibility of a new project proposed to be undertaken by LATECH Ltd. The proposed project is intended to introduce a new game console which is named as NEUROPOWER. The gaming console could be connected to the brain functions of the humans and its prolonged application could lead to impose adverse impacts on the human behavior. The proposed project involves significant capital investment and has an estimated life of 7 years due to which it is necessary to evaluate its financial feasibility using various capital budgeting techniques such as Net Present Value Method, Discounted Payback Method and Internal Rate of Return Method. Apart from the individual evaluation of NEUROPPOWER, the present report will also undertake the evaluation of another proposed project that is intended to introduce an alternative gaming console which is named as IQFORCE. IQFORCE is a trading game console with an upgraded version. Though, the initial total investment of both the proposed projects is same but the annual cash flows will be different. 

While conducting NEUROPOWER project analysis various points are taken into consideration while determining the cash flows for the purpose of application of capital budgeting appraisal techniques. In the calculation of the cost of equipment the cost of staff training amounting to $ 2,00,000 is not taken into account to calculate as this cost cannot be capitalized since it cannot be guaranteed that the staff members who will be trained will remain with the company till the end of the project. The other cost related to brining the equipment in the working condition will be included in the calculation of equipment cost. Such cost includes acquisition cost, import duty, installation charges. The NEUROPOWER project analysis illustrates that the transportation costs paid by the supplier will not be included in the total cost of equipment as it is not paid by the company. The depreciation will be charged on the sum total of all the three aforesaid costs. The capital loss at the end of project life will be calculated as the project will be terminated after 7 years but the equipment will have an economic useful life of 10 years. The capital loss will be calculated by deducing the salvage value from the written down value at the end of 7^th year and it will be subjected to tax benefit at the end of 7^th year. The tax benefit on the said capital loss of $ 8040000 will amount to $ 2412000 as the corporate tax rate of 30%. While determining the overall cash flows the fees that has been given to the analysts amounting to $1 million will not be considered as it is already incurred and hence a sunk cost for the company. There is no relevance of such cost in the project’s cash flows calculation. Further, the NEUROPOWER project analysis also mentions that the inflow avoided on account of discontinuing the existing project line will amount to $21000 per month. Apart from this, the cost of market analyst who will be hired for the term of project will be taken into account as an outflow of cash. The depreciation on the equipment is charged at 10% per annum and it is deducted from the operating cash flows for the purpose of taking its tax benefit. Since, depreciation is a non cash item it will be added back to the cash flows after considering the tax effect so as to reach to actual cash flows. The working capital investment involves a net cash outflow of $ 1400000 as a result of increase in accounts receivable and inventories and increase in accounts payable.

Findings
Quantitative: The net present value of the project NEUROPOWER is $ 1184479.72 positive and hence it implies that the proposed project will be able to generate certain returns for the company after paying off all the costs and expenses related to it (Rossi, 2015). However the required payback period of the company is 5 years but as per the calculations made here under the discounted payback period of this project is higher than 5 years which is implies that the project will take more than 5 years to recover all the costs incurred in the project and it will go beyond company’s expectations. The internal rate of return of the company is the rate at which the project remains at the point where project remains with zero cash inflows and cash outflows (Bennouna, Meredith, & Marchant, 2010). Ideally the IRR must remain higher than the required rate of return of the company. But, in the present case, the IRR calculated is 5.08% which is quite less than the company’s required rate of return of 16%. Hence, the project is not financially feasible.

Next after analyzing the feasibility in the NEUROPOWER project analysis, the analysis of IQFORCE will be undertaken using the same capital budgeting techniques. The initial total investment of IQFORCE will be same as that of NEUROPOWER and it is assumed that there will be no cash inflow from the sale of equipment and also the working capital will not be recovered and hence there will be terminal cash flow at the end of 7^th year. The Net Present Value of IQFORCE will be $ 13194644.03 with a payback period of 3.81 years and IRR of 24.69%. Hence, the project seems financially feasible for LATECH Ltd.

Qualitative
The introduction of NEUROPOWER is a risky project as it has certain adverse impacts on human behavior on account of its prolonged application. The groups which are health conscious are also lobbying against such games with detrimental health effects of the same. Further, due to fast technological advancements in the economy and unexpected growth of gaming industry are the factors which are to be considered while taking up the proposed project. Rather than undertaking this project, the company must go with the introduction of IQFORCE as it a safe and upgraded version of gaming consoles and will be preferred more by the general public.

Comparison of NEUROPOWER and IQFORCE
As the NPV of IQFORCE is more than that of NEUROPOWE, it can be said that the IQFORCE will be able to generate higher returns for the company. Also, the payback period of IQFORCE is lower than that of NEUROPOWER and also it is below than the required payback period of the company. Further, the IRR of IQFORCE is way more than that of NEUROPOWER and also it is higher than the required rate of return of the company which is somewhere in between 16% to 22%. Furthermore, the IQFORCE is considered as safe and upgraded version of gaming consoles. Hence, it is more preferred especially by the health conscious groups. Hence, while undertaking NEUROPOWER project analysis, it is stated that both in quantitative terms and qualitative terms, IQFORCE is better than NEUROPOWER.

The cross over rate is the rate of return at which the Net Present Values of two projects is equal. On a graph where the NPVs of both the projects at different rates are plotted, the point at which the NPV lines of both the project intersect each other is called as crossover rate (Alhabeeb, 2016).

The crossover rate in the present case of NEUROPOWER project analysis which involves comparison of NEUROPOWER and IQFORCE is 13.57% and at this point the NPV of both the projects under consideration is equal (McGowan Jr, 2011). Crossover rate is shown in the graphical and tabular format as below:

SERIES 1= NEUROPOWER
SERIES 2= IQFORCE

Recommendations
From the above analysis on the NEUROPOWER project analysis, it can be said that LATECH LTD. must adopt IQFORCE as a gaming console project as it is better than NEUROPOWER on both qualitative and quantitative grounds. The company must consider the safety feature and technological factors as well while introducing a new gaming console.

Conclusion
From the above findings obtained within this study of NEUROPOWER project analysis it can be concluded that IQFORCE is better than NEUROFORCE and hence LATECH LTD must consider investing in the project that will introduce IQFORCE as the new gaming console. Also, it can be said that application of capital budgeting techniques in such scenarios where huge investments are involved along with large time frame, proper analysis of the project’s feasibility in financial, social and technical terms must be taken into account in order to take informed decisions.

References
Alhabeeb, M. J. (2016). Comparative Analysis of the Traditional Models for Capital Budgeting. NEUROPOWER project analysis International Journal of Marketing Studies, 8(6), 16-32.

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

McGowan Jr, C. B. (2011). Solving for the Time Disparity Crossover Point. In Allied Academies International Internet Conference (Vol. 13, p. 14).

Rossi, M. (2015). The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, NEUROPOWER project analysis 8(1), 43-56.