Solutions to Capital Budgeting Questions - Assignment Example

The after-tax amount received  from selling the old ATM is then subtracted from the amount required to pay for the installation of a new ATM will lead to the figure of Net Investment   Net Investment=                                                                                                                                                      Investment Required to purchase the ATM- Amount Received by Selling Old ATM (1-Marginal Tax Rate)   The bank will receive the current market price by selling the old ATM, which is $200,000. The amount received is subject to a marginal tax rate of 40%.   As the initial investment is calculated in the previous question, the remaining cash flows are calculated using the following formula   Cash flows= Incremental Revenue-Net Working Capital-Annual Maintenance Cost   The incremental revenue is the increased amount of revenue, which is solely linked to the additional revenue generated from the installation of the New ATMs. The installation is subject to an increase in revenue by $300,000 at the end of the first year of installation. Therefore, the amount of $300,000 is shown in year 1. The revenues have shown a constant growth rate of 5% from the second year onwards. Therefore, the increased amount of revenues has been incorporated while calculating the cash flows of the project.   In the case of Net working capital, which shows an increasing trend over the period with a growth rate of 6%, represents cash outflows. Net working capital is calculated as follows   Net Working Capital= Current Assets- Current Liabilities   Therefore, the increase in the Net working capital is subject to the cash outflow. In other words, the purchase of inventory increases the current assets and also increases the net working capital of the organization but the increase in inventory requires cash outflow. On the other hand, the reduction in net working capital implies an increase in the cash inflow. The reason is that the increase in current liability implies an increase in short-term borrowing. The increase in short-term borrowing is subject to a reduction in net working capital but an increase in cash inflow. Therefore, the reduction in net working capital increases the cash inflows, which are then added to the incremental revenues.  The net working capital has shown an increasing trend with a constant growth rate of 6%. The incorporation of the growth rate of net working capital increases its value and reduces the incremental revenues by such increased amounts of net working capital.   The annual maintenance cost is $10,000 at the beginning of the project and shows an increasing trend with a constant growth rate of 5% each year.  The incremental cost is then subtracted from the incremental revenues each year.    The depreciation is a non-cash item. Therefore, it is not incorporated in the calculation of cash flows each year. The growth rates of each factor are also shown in the table and the cash flows are calculated considering the growth rate of each element   Compute the net present value of this project, assuming the ATM to be of average risk.   Net Present Value of the Project To calculate the NPV of the project, the cost of capital is needed to be calculated first. The formula for WACC is as follows WACC=Rd⁡〖D/(D+E) (1-Marginal Tax Rate)〗  〖+Re〗⁡〖E/(D+E)〗   D= Market Value of Debt including preferred stocks= $925 E= Market Value of Equity= $30 Marginal Tax Rate= 40% Re= Rf+β(Rm-Rf)= 5%+ 1.5(15%-5%)= 20% Rd= Return on Debt= 11.75 %( As calculated using Coupon, Par value and Current Price)   Wacc= 7.44% NPV=Initial Cost +Cf1/DR+Cf2/(DR^2)+CF3/(DR^3)+CF4/(DR^4)+CF5/(DR^5),+CF6/(DR^5)   =$389,703.17   Based on the calculations performed in Questions 1-3, should First National purchase the new ATM?   Net Present Value of the Project Positive NPV implies an increase in the value of the project. Therefore, First National should purchase the new ATM   Assume that First National requires projects to have a payback of less than 4 years.  Under these conditions, should it purchase a new ATM?    Decision-Based on Payback Period As the breakeven of 880,000 reaches before 4 years, so bank should purchase the new ATM.   Payback Period=(Initial Investment)/(Cash flow per year)   As the cash flow per year varies so the other way to calculate the payback period is that sum the cash flows and identify when it will reach the initial net investment of $880,000 As we can see in the cash flow table that the sum of the first four-year cash flows crosses $1000,000. Therefore, the actual payback period is less than 4 years What is the cost of capital?   Cost of Capital Re= Rf+β(Rm-Rf)= 5%+ 1.5(15%-5%)= 20%                Rd= Return on Debt= 11.75 %( As calculated using Coupon, Par value and Current Price)   WACC=Rd⁡〖D/(D+E) (1-Marginal Tax Rate)〗  〖+Re〗⁡〖E/(D+E)〗 D= Market Value of Debt including preferred stocks= $925 E= Market Value of Equity= $30 Marginal Tax Rate= 40% WACC= 7.44%   Should the bank purchase the new ATM?

Decision
The bank should Purchase the New ATM because the net present value increases the value of the bank by giving the positive value Read More