The Initial Investment and the Depreciation Tax Saving - Case Study Example

The Initial Investment and the Depreciation Tax Saving Question 1 The initial investment includes the cost of machine and the installation cost. The initial investment in year 0 is written as a negative number to depict the outflow of cash. The figure in year 0 indicates the amount that GP Manufacturing will have to invest to obtain the machinery. The depreciation tax saving is the amount that GP Manufacturer will be saving because as depreciation is charged as an expense in the income statement, the earnings before tax will decrease; hence, less taxes will be charged compared to when no depreciation was charged. Thus, the company will save in taxes because of the depreciation. The incremental cash flows show the amount of cash that will be generated after the project is considered and initial investment is made. The estimated cash generated from the investment over the useful life of the asset will enable the company to apply any capital budgeting technique to determine whether the project should be considered or not. Question 2 years net cash flow discount factor NPV 0 -302040 1 -302040 1 70456 0.893 62917.21 2 83546 0.797 66586.16 3 69365 0.712 49387.88 4 61730 0.636 39260.28 5 60639 0.567 34382.31 6 55185 0.507 27978.8 7 48640 0.452 21985.28 8 58240 0.404 23528.96     NPV 23987 Net present value is positive; hence, this project should be pursued by GP manufacturing. NPV is an important capital budgeting tool which enables the company to analyze the estimated future flows by converting the future cash flows in to their present value and comparing them with the initial investment. If the sum of the cash flows and the initial investment is positive, the project is accepted and if it is negative, the project is rejected. The NPV of a particular project for GP Manufacturing will be different compared to other potential customers because the cost of installation might differ also the cost of uninstalling the existing machine and the scrap of the existing might differ. Hence, the initial investment will be different. Also, the cost of capital percentage might differ. The higher the cost of capital the lower the net present value because the discount factor will change. Furthermore, the cash flow of GP Manufacturing and other potential customers will be different; hence, the net present value will differ. Question 3 The IRR is 14% which is greater than the cost of capital; hence, the project is worthwhile. IRR is a rate at which NPV is zero. If the cost of capital exceeds the IRR, then the NPV will be negative. Thus, the internal rate of return should always exceed cost of capital for the project to be acceptable. The IRR of a particular project for GP Manufacturing and other potential customers might be different because the cash flow to each company might be different. Furthermore, the initial investment might be different because of the different cost of installation of new machine. Also, there might be uninstalling cost of previous machinery or there might not be any old machines. Thus, the installing cost will be different which will ultimately affect the initial investment. As a result, the IRR will be affected and will be different of other potential customers compared to GP Manufacturing. Question 4 a) years net cash flow cumulative cash flow 0 -302040 -302040 1 70456 -231584 2 83546 -148038 3 69365 -78673 4 61730 -16943 5 60639   6 55185   7 48640   8 58240   Payback period= 4+ (16943/60639) = 4.27 years or 4 years, 3 months and 11 days b) The payback period tells the number of years required to recover the total amount that is investment in year 0. The quicker the company will be able to recover the funds, the more attractive the project will be. Hence, in this type of capital budgeting technique, companies select the project with the shortest payback period. c) Payback does not take in to account the time value of money. It considers the actual amount of cash flow over the payback period instead of discounting them for time value of money. Also, payback does not consider any cash flow after the expiration of the payback period. If the company recovers the initial investment in four years, then this method would not consider any cash flows after four years. Furthermore, the acceptance criterion is a crude measure of project cash flows and is subjective rather than objective compared to other capital budgeting techniques. d) Payback period provides a rough guide of the liquidity of the project but does not provide any useful information about the profitability of the project. e) In this scenario, payback period will play a vital role in allowing the organization choose one option as payback can show how quickly or slowly initial investment can be earned back for each of the options. In cases, where the equipment does not require any outlays of cost further down the road other than the initial investment, payback period can be applicable while in other scenarios it might not be as helpful. f) For projects that have very long or short lives, such a measure will not be applicable as the rate of return will actually not be representative of the actual payback period and return on the investment. When projects have very long lives, the return measure will not aptly measure how quickly the investment has been earned back and same is the case with projects of shorter lives. Question 5 The MIRR for the project is 13% which is greater than the cost of capital and thus gives enough returns to make this project viable for the organization. In that respect, this project should be accepted if MIRR is the base for taking the investment decision. Technically, MIRR is a better choice for making a decision than IRR for the reason that MIRR takes into account both negative as well as positive cash flows for the investment. Question 6 The profitability index of GP Manufacturing is 1.68. The PI ratio should be at least 1.0; this is the lowest acceptable measure. Any value which is lower than 1.0 is not acceptable. However, as the PI increases the financial attractiveness of the project also increases. The GP Manufacturing PI is 1.68 which is favorable; hence, the project is financially attractive for the company. Question 7 In case when there are no negative cash flows or any abnormalities in a regular pattern of cash flows in a project, all measures would be able to give the same answer, either a rejection or acceptance of the project. However, in case when a conflict occurs, such as negative cash flows over the course of the project, then NPV and MIRR are the best choices to consider projects and their viability. Question 8 With tax credit, returns on the project each year would increase and thus the project viability will naturally increase. This can be evaluated through a fresh calculation of the NPV, IRR, MIRR and PI as they all show an increase since positive cash flows for the project for each year would increase. Question 9 The graph can help evaluate at which rates the project can be viable for the organization and till which point the company can still make a reasonable investment into the project with an expectation to earn some returns. The profile shows that just below 15% the project will not be feasible for the organization any more. Question 10 The short term project for low quality systems has an NPV of $6,250.00 and an IRR of 17%. The NPV profile for both the projects is shown below: For both these projects, it is important negative cash flows do not exist as otherwise the analysis and evaluation of the projects will be extremely different, and returns will be difficult to predict. If both the projects are independent, then the company can choose either or both of the projects as they are viable, but in case of mutually exclusive projects, one of the two will have to be selected. Question 11 a) It is important to note that initial investment levels have to be fulfilled therefore, the projects will be viable only till such that they are able cover the initial investment cost. Each variation should be accounted for and a fresh NPV evaluation should be conducted to test this viability. b) In case of variation in cost of capital, a similar analysis through NPV will have to be conducted. Financial viability stands till the time that the company is able to cover its costs therefore, even with fluctuation in cost of capital, IRR and NPV should be taken into account. c) This will increase the MIRR as the amount of return is higher than the amount of cost in percentage terms that has to be incurred for the project. In that respect, the company will find the project more feasible and financially acceptable. d) For each percentage decrease in the tax rate, earnings for each year on the project will increase; however, with each percentage increase, the earnings will decrease, therefore, NPV will have to be evaluated to test the financial feasibility of the project. e) Basic analysis on sensitivity can be done quite quickly and easily on a laptop however, detailed and more profound analyses would require better equipped machines and more than simple spreadsheets for analysis as sensitivity analysis tools on spreadsheets are very simplistic. Question 12 The NPV for the project is $1,020.41, IRR is 11% and MIRR is 3% with an NPV profile as below: With negative cash flows of the project, the NPV profile indicates that at higher rates the project will be feasible for investment while at lower rates it will not be financially wise to invest in this project. Read More