Cash Flow and Capital Budgeting - Assignment Example

Finance and Accounting finance Table of Contents Question1 3 Question 2 3 Question 3 6 Question 4 8 References 11 Question1 The information, which has been initially presented, was not firstly presented in a proper format but after two consecutive meetings, much other information were unearthed such as the machine could be sold at the end of four years. Most of the information, presented, is on an additional information basis gathered at the meetings. Even the calculation done, is based on the finding of the cash flow decision. The payback period is used for the calculation. The payback period determines how much cost will be required to launch the project, finally how much time it will take to breakeven or even gather, and generate enough money to fulfill the startup costs incurred. Therefore, the company usually discards the projects, which have longer payback, and the ones with the shorter payback period are usually accepted. The payback period is faulty because it has many problems associated with it such as it does not take into account inflation or the cost of capital. Thus, this is the reason why the payback period used by most of the companies because they do not give an accurate impression of the cost of the project. Thus, all the information assimilated, is in the payback period fashion. On the calculation of the payback period, the investment decision was made (Alberto Magni, n.d.). Question 2 The cost figures that were discovered later on which were produced by the financial accountants and the further information which were produced indicates that if the project is accepted then there would be negative value of the project (Auburn University, n.d.). The calculations undertaken for this project were calculation of the operating cash flows. In performing these calculations the additional information which were gathered were written down and segregated on the four year basis (California State University, n.d.). Initially the depreciation of the new machine was calculated on the written down value basis. In the written down value basis the portion of the cost of the machine, which has been accounted for in depreciation, is subtracted so as to the value of the machine decreases as the life of the machine increases. The calculation of the depreciation of the machine is presented below in a table format. Depreciation(20% WDV) Yr 1 Yr 2 Yr 3 Yr 4 900000 180000 144000 115200 92160 720000         576000         460800         The initial cost of the new machine was 900000 pounds. In year one it depreciated by 180000 pounds in the second year it depreciated by 144000 pounds, in the third year 115200 pounds and finally in the fourth year 92160 pounds. The written down value is further called the book value method or the net value method of accounting for amortization. It follows the diminishing value approach in which after the completion of each year the value of the asst decreases or diminishes. Further, the operating inflows of the project life are calculated by the information that was acquired from the additional information. The cash outflows calculated throughout the life of the project so are the cash inflows. The cash outflows are the money that have to be invested not only in the starting of the project but also throughout the life of the project. However, there are no initial cash inflows for many years. The cash inflow begins after a long time into the project. The depreciation incurred on the machine, is also a type of cash inflow of the project. The after tax decrease in cost is the costs which is decreased in the operating costs due to the installation of the new machine. This is then calculated after taking into account the cost factor. Tax savings from depreciation is the tax saved from paying out on the account of the depreciation, which was accounted. The deprecation of machine provides varied benefits to the project. The operating cash flows, accounted for, are used to calculate the net operating cash flows. Operating Inflows over the Projects life                   Depreciation on new machine 180000 144000 115200 92160 Materials 90000       After tax decrease in costs 18750 18750 18750 18750 Tax savings from depreciation 45000 36000 28800 23040 Materials ( if not used then ) 40000       Net operating Cash flows 193750 54750 47550 41790 The new machine that is to be bought is of 9 million pounds worth. Further the operating costs that the new machine would have reduced if bought was two thousand pounds. If the new machine was bought then the old machine could be sold off for twenty five thousand pounds. Further, the net working capital was said to have increased by 80000 pounds, which were to be paid back in 80% at the end of the project life. Cost of new machine 900000       Reduction in operating cost 25000   Increase in net after tax cash flows due to cost reduction 18750.00 New machines salvage value at the end of 4 years 120000       Old machines salvage value 25000       Increase in Net operating WC 80000       Tax rate 0.25       WACC 11.40       Question 3 The minimum return of the project was calculated to be 11.4 percent. The calculation of the minimum return was done based on capital asset pricing model. The calculation of the capital asset pricing model was done in the following fashion (Cash Flow and Capital Budgeting, n.d.). William Sharpe, John Linter, and Jan Mossin discovered the capital asset pricing model. The formulae can be used in various different ways. but mostly in capital budgeting decisions this formulae is utilized for finding out the rate of return of an asset or a project . it is the factor which decides whether the project or proposal under review is economically viable or not. The model takes into account both the diversifiable risk and the unsystematic risk. The beta here is the non- diversifiable risk that is taken into consideration while calculating the formulae. The CAPM can be utilized in the corporate finance in building the hurdle rates in the projects of the firm. The hurdle rates if not calculated then the projects would not be able to be appraised by the finance people. The risk of the project was also calculated to asses if the project, which was undertaken if that, will affect the value of the firm if it is undertaken. The risk is calculated because to see if the project is actually viable to be undertaken. The three risks, which are assessed while undertaking a project, are standalone risk, corporate risk or the risk existing within the firm and beta or the market risk under association of the project. The standalone risk of the project is the risk that exists with the mere undertaking of the project. The organization will be faced whenever the organization will take up any new project with the risk. If the organization does not take up any project then the organization may experience an opportunity loss. The stand-alone risk may be dealt in a fashion in which the sensitivity analysis of the project is conducted to in which the NPV of the project changes with the changes in the input of the project. Further scenario analysis of the project may also be used for the analysis of the standalone risks. These risks can be segregated based on optimistic, pessimistic and moderate based on the scenario analysis of the project. The Monte Carlo simulation is also another technique that could be applied for the situational risk analysis of the project (Cengage Learning, 2003). The corporate risk is the risk that is existing within the firm or the company that is thinking of undertaking the project. If the firms want to negate the corporate risk then it would have to invest in projects that are negatively related in nature (Chen, 2014). The beta of the project in concern is the market risk that is involved. The beta of the project is used to calculate and measure the impacts of the project on the existing assets owned or held by the company in general. Beta 1.4 Rf 0.04 Market premium 0.074     Expected return 0.114 Rm 0.092857143 Question 4 The capital budgeting topic deals with the decisions of the firm concerning the use of the long term fixed assets. The capital budgeting decisions of any company are highly important because these decisions affect the firm in various ways  (Fama and French, 2004). Further, the decisions undertaken by the capital budgeting process goes a long way because the financial viability of the project decides the course of the way for new revenues for the project (Finance Formulaes, n.d.). Further the assets which are utilized under capital budgeting are mostly long-term assets therefore a lot of investments of the company go in them (Florida International University, n.d.). Their proper utilization is also very necessary because that paves the way of the revenue generation for the company. A bad decision may cost the company quite adversely because the projects re very costly in nature  (Krause, n.d.). Further, the capital budgeting decisions also decide the firms buying of the assets or the fixed assets. The fixed assets of the firm are bought or replaced. If the decisions of the firm are made in haste then too it can be quite costly for the company because decisions taken in haste may cause the firm to incur heavy losses. There are different types of capital budgeting decisions for example the replacement decisions, expansion decisions and the independent projects. The replacement decision decides if an existing machinery can be replaced or should it be replaced with a newer version of the machine or another advanced machinery which would in turn aid the company and the project Pearson Education, 2014). The expansion decisions are the projects which helps the company to decide to expand into a newer horizon or to drop the expansion plans. The independent projects are the different projects taken up by the organization for its personal benefits (Sanfransisco state University, n.d.). The project that is being dealt here is a replacement decision (Shapiro, n.d.). The company wants to replace the old machine in consideration with a newer machine that would cost the company nine million pounds. The capital budgeting is sometimes considered synonymous to asset valuation because the cost of the project in consideration and the value of the project in consideration is compared (Sigman, 2005). The evaluation technique that was used by the compny formally was the payback period method but now the assessment technique has changed to the net present value method  (Welch, 2014). The net present value method of the project was computed to calculate the future cash flows that would be generated from the project in concern and then they would be converted to the present value of the project. These accumulated present values would then have to be subtracted from the amount that is being invested in the initial project. The project is finally considered acceptable if the net present value of the project sums up to positive value. If the net present value of the project is negative then the project is discarded or abandoned. The typical replacement of the machine requires item-by-item comparison of the different costs incurred during the existing machine’s lifetime and the new machine’s lifetime. This would include the subtraction of the tax adjusted salvage value of the old machine too. Both the machine’s total cost are calculated in comparison from the time zero. The tables below provide the calculation of the total cash flows of the new machine in concern and finally the calculation of the net adjusted present value of the machine. Since the net adjusted present value of the machine has amounted to negative value even after careful consideration the project is cancelled and discarded. Investment Outlay 0 1 2 3 4 Cost of new equipment -900000         Old machines salvage value 25000         Increase in Net operating WC -80000         investment in ad and promotion -25000 -12000 -12000 -12000   Market research -26000         Materials controller 0 -24000 -24000 -24000 -24000 Operations supervisor 0 -50000 -50000 -50000 -50000                                     Operating Inflows over the Projects life                       Depreciation on new machine   180000 144000 115200 92160 Materials   90000       After tax decrease in costs   18750 18750 18750 18750 Tax savings from depreciation   45000 36000 28800 23040 Materials ( if not used then )   40000       Net operating Cash flows   193750 54750 47550 41790                                     Estimated Salvage value of new machine         120000 Tax on Salvage value         30000 Return of net operating WC         64000 Total termination cash flows         154000                         Net Cash flow -1006000 107750 -31250 -38450 121790     -898250 -929500 -967950 -846160   year Expected return cashflow     1 1.114 -898250 -806328.5458   2 1.114 -929500 -748995.162   3 1.114 -967950 -700160.0897 NPV 4 1.114 -846160 -549429.1889 References Alberto Magni, C., n.d. CAPM and capital budgeting: present versus future, equilibrium versus disequilibrium, decision versus valuation. 1st ed. [ebook] Available at: http://merlino.unimo.it/campusone/web_dep/materiali_discussione/0562.pdf [Accessed 7 Aug. 2014]. Anon, n.d. Cash Flow and Capital Budgeting. 1st ed. [ebook] Available at: http://www.cengage.com/resource_uploads/downloads/0324406088_44407.pdf [Accessed 7 Aug. 2014]. Auburn University, n.d. Capital Budgeting: Estimating Cash Flows and Analyzing Risk. 1st ed. [ebook] Available at: http://harbert.auburn.edu/~yostkev/teaching/finc3630/notes/Chapter13solutions.pdf [Accessed 7 Aug. 2014]. California State University, n.d. Capital Budgeting. 1st ed. [ebook] Available at: http://www.csun.edu/~zz1802/Finance%20303/Lecture-Notes-Final.pdf [Accessed 7 Aug. 2014]. Cengage Learning, 2003. REPLACEMENT PROJECT ANALYSIS. 1st ed. [ebook] Available at: http://www.swlearning.com/finance/brigham/ffm10e/web_cd_appendixes/11B.pdf [Accessed 7 Aug. 2014]. Chen, S., 2014. 1st ed. [ebook] Available at: http://abeweb.org/proceedings/proceedings08/chen.pdf [Accessed 7 Aug. 2014]. Fama, E. and French, K., 2004. The Capital Asset Pricing Model: Theory and Evidence. [online] Pubs.aeaweb.org. Available at: http://pubs.aeaweb.org/doi/pdfplus/10.1257/0895330042162430 [Accessed 7 Aug. 2014]. Finance Formulaes, n.d. Net Present Value. [online] Financeformulas.net. Available at: http://www.financeformulas.net/Net_Present_Value.html [Accessed 7 Aug. 2014]. Florida International University, n.d. CAPITAL BUDGETING. 1st ed. [ebook] Available at: http://www2.fiu.edu/~keysj/CFIN_09.pdf [Accessed 7 Aug. 2014]. Pearson Education, 2014. Capital Budgeting Techniques. 1st ed. [ebook] Pearson. Available at: http://wps.aw.com/wps/media/objects/222/227412/ebook/ch09/chapter09.pdf [Accessed 7 Aug. 2014]. Sanfransisco state University, n.d. Net Present Value and Capital Budgeting. 1st ed. [ebook] Available at: http://online.sfsu.edu/donglin/Ch007.pdf [Accessed 7 Aug. 2014]. Shapiro, A., n.d. Foundations of Finance: The Capital Asset Pricing Model (CAPM). 1st ed. [ebook] Available at: http://people.stern.nyu.edu/ashapiro/courses/B01.231103/FFL09.pdf [Accessed 7 Aug. 2014]. Sigman, K., 2005. Capital Asset Pricing Model. 1st ed. [ebook] Available at: http://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-CAPM.pdf [Accessed 7 Aug. 2014]. Welch, I., 2014. The Capital Asset Pricing Model. [online] book.ivo-welch.inf. Available at: http://book.ivo-welch.info/ed3/chap09.pdf [Accessed 7 Aug. 2014]. Krause, A., n.d. An Overview of Asset Pricing Models. 1st ed. [ebook] Available at: http://people.bath.ac.uk/mnsak/Research/Asset_pricing.pdf [Accessed 7 Aug. 2014]. Read More