The Life of the Project - Essay Example

The life of the project consists of initial investment, operating cash flow, and terminal cash flow. The underlying concept of initial investment includes cash outlay, working capital, salvage value, and tax implications. The factors that are involved with the initial investment are; purchase price, cash from the sales of old equipment, marginal income tax, increase in working capital, cost of shipping, and installation of new equipment. The factors that are involved with the operating cash flows are; sales revenue, cost of production, income before taxes, marginal tax rate, depreciation, increase in working capital. The factors that are involved in terminal cash flow are; decrease in working capital, salvage value, marginal income tax rate.

The criteria for capital budgeting include (1) cost of capital, (2) opportunity cost, and the break-even point. The cost of capital determines the cost of borrowing to pay for the project. This value sets the benchmark for the lowest possible return. This benchmark shows if the investment is worth compared to their investments.  Opportunity cost determines the cost for taking advantage of one option over another.  The Break-even point determines if the project would contribute to the growth of the company.  Break-even is the point at which sales equals cost.  The Break-even point involves determining fixed and variable costs.  Fixed costs are values that do not depend on production quantity.  These costs are rent, salary, insurance, etc. Most of the variable costs are associated with raw material, utility, and transportation.

How did the use of tools, such as payback, NPV, and IRR, help you in evaluating the fully equipped facility cost?

Capital budgeting techniques are explicit formulas for the analysis of financial values that determine if a company should proceed with the planned investment or not.  Some of them are (“Investment decision – Capital Budgeting”) Net Present Value (NPV), Internal Rate of Return (IRR), and Payback methods.  All three methods use Operating Cash Flow (OCF) values.  The OCF evaluates net cash flow for each year of project operation.  The OCF is evaluated for the life of the project, and it ends with the evaluation of Terminal Cash Flow. OCF determines the value of net annual cash flow during the project life.  Net annual cash flow is the money that a project generates after paying taxes.

NPV evaluates the present value of the future cash flows that the project generates during its life.  In simple language, if the value of money generated during the project life is higher than the initial investment, the project makes money.  The formula is NPV = - Initial investment + sum of discounted values of each year's net cash flow during the project life. The term “discounted cash flow” is critical in evaluating NPV.  It determines the value of an annual cash flow with the time value sensitivity using the cost of capital. Thus, NPV takes care of; initial investment, cost of capital, and income generated by the project.  If the value of NPV is less than zero, the project is rejected.  If the value of NPV is greater than zero, the project is considered.

IRR is the cost of return at which all cash inflows (revenues) equal the present value of cash outflows (initial investment plus any other expenses).  In another way, it is the cost of capital at which NPV is zero.  This means the project did not generate any growth.  Like NPV, IRR also considers discounted values of the year's net cash flow for the project of life.  If IRR is less than the cost of investment (capital), then the project is rejected. Thus, IRR considers; initial investment, cost of capital, and income generated by the project. The payback period calculates the length of the time it will take to get the ack company’s initial investment. This method considers; initial investment and unadjusted net cash flow of each year until the investment of the project are paid off.  The payback period does not consider the time value factor of money and the life of the project.  It only provides a rough idea for making capital project investment decisions.  It does not have a standard for acceptability. Among the above-mentioned three tools, NPV and IRR are recommended techniques for making capital project investment decision, since it considers the time value factor of money and the project life.