How is a project classification scheme (for example, replacement, expansion into new markets, and so forth) used in the capital budgeting process? Project classification schemes can be used to indicate how much of an analysis is required to evaluate a given project, and the level of the executive who much approve the project, and the cost of capital that should be used to calculate the project’s NPV. By doing so, classification schemes can increase the efficiency of the capital budgeting process. 9. Explain the decision rules—that is, under what conditions a project is acceptable—for each of the following capital budgeting methods: a. Net present value (NPV) b. Internal rate of return (IRR) c. Modified internal rate of return (MIRR) d. Traditional payback (PB) e. Discounted payback (DPB) a. Should only be undertaken if NPV is greater than 0. b. Should only be undertaken if IRR is greater than the cost of capital. c. The MIRR will yield the same as the IRR method, so it would need to be greater than the cost of the capital. d. Should only be undertaken if PB is less than the arbitrary number of years. . Should be undertaken if it has the shortest payback period, and can be used to identify the project that will generate more cash for investment quickly. 9. 6 In what sense is a reinvestment rate assumption embodied in the NPV and IRR methods? What is the assumed reinvestment rate of each method? The NPV and IRR methods both involve compound interest, and the math of discounting requires an assumption about reinvestment rates. The NPV method assumes reinvestment at the cost of capital, while the IRR method assumes reinvestment at the IRR.
IRR assumes that all cash flows are reinvested at the project’s rate of return. Since NPV discounts future cash flows at the investor’s cost of capital, is more accurately represents the value of a project and assumes that cash flows are reinvested at the cost of capital. 9-1 A firm is evaluating the acceptability of an investment that costs $90,000 and is expected to generate annual cash flows equal to $20,000 for the next six years. If the firm’s required rate of return is 10 percent, what is the net present value (NPV) of the project? Should the project be purchased? $2,895, no it should not be purchased. 9-3 What is the internal rate of return (IRR) of a project that costs $45,000 if it is expected to generate $15,047 per year for five years? 20% 9-5 Plasma Blood Services is deciding whether to purchase a new blood cleansing machine that is expected to generate the following cash flows. What is the machine’s IRR? Year Cash Flow 0 $(140,000) 1 60,000 2 60,000 3 60,000 13. 7% 0-1 Cash flows rather than accounting profits are listed in Table 10-2. What is the basis for this emphasis on cash flows as opposed to net income? Net income essentially shows the income which the project or company get after deducting cost of goods sold, selling and general expenses, depreciation, amortizations, interest (if any), and tax from revenue. In fact net profit is unable to show the real picture of cash available. Operating Cash flows shows the real picture of cash available because in cash flows non cash expenses items such as depreciation and amortization are add back.
Further, interest expense is not operating activity; it is financing activity which is not included on operating cash flow. Therefore, company emphasis on cash flows as opposed to net income. 10-2 Look at Table 10-4 and answer these questions: a. Why is the net salvage value shown in Section III reduced for taxes? b. How is the change in depreciation computed? c. What would happen if the new machine permitted a reduction in net working capital? d. Why are the cost savings shown as a positive amount? 10-3 Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included.
Sunk costs are those expenses which have already occurred. These costs do not really affect the decision whether or not to accept the new project. Further, sunk cost is one time cost so it does not increase as the company implements additional projects. Therefore sunk cost should not be included in a capital budgeting analysis. For example, previous years R&D cost of company is sunk cost. Therefore, if company is going to implement project this year R&D cost should be excluded. Opportunity costs are those cash flows that company could have generated from assets the company already own.
Since company has to give up those cash flows to implement another projects, they have to include those cash flows in capital budgeting. Externalities are effects a project has on other parts of the company as well as on the environment. For example, when company introduces new products it may affect the sales volume of other product offered by same company as well as sales volume of its competitors. This effect is also called cannibalization effect, because the new business or new product eats the company’s existing business or product.
The lost cash flow should be adjusted on new projects. 10-4 Explain how net working capital is recovered at the end of a project’s life and why it is included in a capital budgeting analysis. In order to support the new projects additional inventories are required and firm gets its additional inventories from its vendors as a result account payable as well as accruals increases. While because of the expansion of company towards new projects company’s revenue also increase and tie up as additional accounts receivable.
Therefore, the difference between increase in operating current assets and the increase in operating current liabilities is the change in net operating working capital. At the end of the project’s life all the additional account receivable are collected where as all additional inventories will be used. As all receivable will be collected, all accruals and payable will be paid by the end of projects. In this way new operating working capital is recovered at the end of a project life. Capital budgeting is the technique of analyzing potential projects.
Capital budgeting helps to identify the various cost associated with project, cash flows of projects and ultimately help to make decision whether or not to acquire that project. Since operating working capital (inventories) is essential element of project it is included on capital budgeting analysis. 10-5 In general, is an explicit recognition of incremental cash flows more important in new project analysis or replacement analysis? Why? In replacement projects, the benefits are usually cost savings, but the product may permit additional output.
The data for replacement analysis is easier to obtain for older than newer products, but the analysis is more complicated due to almost all of the cash flows being incremental, which is found by taking the new numbers away from the old numbers(subtraction). Differences in depreciation and any other factor that may affect cash flow must also be used and determined. 10-1 PowerBuilt Construction is considering whether to replace an existing bulldozer with a new model. If the new bulldozer is purchased, the existing bulldozer will be sold to another company for $85,000. The existing bulldozer has a book value equal to $100,000.
If PowerBuilt’s marginal tax rate is 35 percent, what will be the net after-tax cash flow that is generated from the disposal of the existing bulldozer? $90,250 10-2 A company has collected the following information about a new machine that it is evaluating for possible investment: Purchase Price $340,000 Salvage value at the end of 3 years $15,000 Shipping and installation $50,000 Book value at the end of 3 years $5,000 Marginal Tax rate 40% a.
What is the machine’s depreciable basis—that is, the amount that can be depreciated during its life? b. In three years, what will be the net cash flow generated by the disposal of the machine? $390,000 b. In three years, what will be the net cash flow generated by the disposal of the machine? $11,000