Capital Budgeting - Essay Example

Capital Budgeting Capital Budgeting Capital Budgeting Exercise Machine A Year 0 2 Investment (1000) Maintenance Cost (300) (300)Cash Flows(1000)(300)(300)Discount Factor (8%)10.92590.8573Discounted Cash Flows(1000)(278)(257)Net Present Value = 1535Equivalent Annual Cost (EAC) = Net Present Value/ Annuity factor (t,r)EAC = 1535/ 1.7833EAC = $ 860.7Machine BYear0123Investment(1300)Maintenance Cost(200)(200)(200)Discount Factor (8%)10.92590.85730.7938Discounted Cash Flows(1300)185171159Net Present Value = 1815EAC = 1815/ 2.

5771EAC = $ 704.28 Equivalent Annual Cost is a method which is used to ascertain the cost of possessing an asset over the period of its life. The method is popularly adopted by firms while making capital budgeting decisions. Usually the EAC method is used to compare two different projects but it is also used when analyzing the cost effectiveness of two or more different assets. The method is best used in situations where there are varying lifespans of different projects. The method is considered to provide a good comparison between two different assets since it uses the Net Present Value approach which takes in consideration the time value of money.

Following the EAC calculation, it can be strongly concluded that the company should purchase Machine B since it has a lower EAC and hence a lower reinvestment. The lower reinvestment would help the company in saving cash for its daily operations and would also provide in improving its profitability. Capital Budgeting Exercise 2Year0123Sales800,000800,000800,000Fixed Costs(300,000)(300,000)(300,000)Depreciation(137,500)(137,500)(137,500)EBIT362,500362,500362,500Taxes (35%)(126,875)(126,875)(126,875)Net Income235,625235,625235,625Operating Cash Flow 500,000500,000500,000Changes in NWC(150,000)(150,000)(150,000)(150,000)Change in Fixed Assets650,000512,500375,000237,500Total Cash Flow500,000862,500725,000587,500Year01234Operating Cash Flow500,000500,000500,000Investment(650,000)100,000Working Capital(150,000)(150,000)(150,000)(150,000)600,000Taxes(126,875)(126,875)(126,875)Cash Flows(800,000)223,125223,125223,125700,000Discount Factor (8%)10.92590.85730.79380.7350Discounted Cash Flows(800,000)206,591191,285177,117514,500Net Present Value = $289,493 Assuming that the Working Capital requirements would all continue till the life of the project and that all off it would be recovered at the end of the life of the project, the NPV that has been calculated is $289,493.

Now since the NPV calculation gives out a positive value, it can be easily concluded that the project is bound to add some value to the company and that the project should be undertaken. Besides the NPV value, the projects profits also depict a favorable condition for the company and it can be certainly derived from this that the project is worthwhile and should be carried out immediately.