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Capital Budgeting for a New Machine - Coursework Example

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Capital Budgeting for a New Machine

Secondly, internal rate of return for a project provides a percentage of the amount of return that the cash flows will generate. It is noted that the required rate of return is 15% however; the return for this project is 22% which provides a 7% spread. These two ground are enough to take up this project. 4. Explain how depreciation will affect the present value of the project. (10 pts) Depreciation is a non cash expense and it is also tax deductible. The depreciation is first reduced from the operating income to get earnings before interest and taxes. The amount of depreciation deducted is then added back in the cash flow statements to get the operating cash flows. We know that the net present value is determined by the cash flows expected from the project therefore; this non cash expense eventually increases the cash flows of the project. Ultimately, the net present value of the cash flows will increase which is beneficial for the company. In addition to the above, a company which opts for straight line depreciation method will have equal positive cash flows every year. For example: Depreciation of $100,000 per year, with an income tax of 35%, saves $35,000 of taxes each year and that amount is accounted as a positive cash flow. This amount is also known as the depreciation tax shield. 5. Provide examples of at least one of the following as it relates to the project: (5 pts each) a. Sunk Cost b. Opportunity cost c. Erosion Sunk cost Sunk Cost is a sum of money which has already been spent and it is not recoverable. It is essential to understand because many people feel intuitively that if an investment is made then it is essential to get a return on it. This will lead to rejection of one course of action which favors the other one to actually generate smaller cash flows. One needs to understand that sunk costs are irrelevant to financial decisions. Opportunity cost is a profit that is forgone by not investing in a particular opportunity. This is particularly true when there are mutually exclusive projects and you have to choose the best out of two good projects. The profit forgone from not choosing the other project is your opportunity cost (Shim & Siegel, 2008). Erosion is the slow but sure redirection of funds from profitable sections or projects within a business to new project and areas. It is considered to be an investment in the long, money flowing in new projects, however; the short run effect is a slow erosion of company cash flows. 6. Explain how you would conduct a scenario and sensitivity analysis of the project. What would be some project-specific risks and market risks related to this project? Sensitivity analysis is a practice adopted by the finance department of a company which is taking up a new project. The cash flows are expected therefore; one needs to ensure that the estimation is true in all cases. For that, one should know which factors would reduce your actual cash flows and which will increase them. So, in this case the variables which are crucial are required rate of return, interest rate risk, discrepancy in cash flows, damage to the equipment etc. Sensitivity analysis of this project would be done against various variables. (Brigham & Ehrhardt, 2010) These may include required rate of return, interest rate risk, discrepancy in cash flows, damage to the equipment etc. Increase in the required rate of ...Show more

Summary

Task 4. Capital Budgeting for a New Machine 1. What is the project’s IRR? (10 pts) To determine the IRR of the project we use the financial calculator, 22% 2. What is the project’s NPV? (15 pts) 3. Should the company accept this project and why (or why not)?…
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