Essentials of Managerial Finance - Research Paper Example

Swindodn plc INTRODUCTION Capital investments involve large sums of money. Thus, errors in deciding whether to pursue a long term investment isvery costly especially when the total cash inflows are less than the cost of the investment. Finance teaches us the theories on whether to pursue or not an investment before the actual cash outlay begins(Weston, 1993. The follow paragraphs focuses on the Swindodn plc company's capital investment case involving 15,000,000. BODY a) The project's Initial Investment (15 marks) New Platform with drill machine Cost 14,000,000.00 Additional cost 1,000,000.00 Total cost 15,000,000.00 The cost of investment includes the amount that the company will have to pay in order to put an equipment, a factory, a building, a delivery equipment and the like into operations so that such assets can generate income for the company and be able to pay for its cash outflow. Thus, fundamentals of accounting tells us that the cost of an assets includes cash paid outright when the assets is bought plus the amounts that will be paid in the future. Such future amounts also includes interest expenses paid for the use of borrowed money(Brigham, 1985) For there are two ways to get an asset, through investment of cash and through creation of loans or long term debts or bonds. In addition, the cost of the assets includes all other cash outlay that will put such assets into operation. Meaning, the additional cost includes trial runs, hauling or delivery expenses to deliver the drills from the supplier's warehouse to the purchaser's factory or place of business(Ross, 1996). For, the cost of capital here includes the drill and platform cost of 14,000,000 and the 1,000,000 additional costs. Evidently, the cost of amount that the company will have to pay in order to put the long term investment into operation. b) The project's Depreciation Schedule (5 marks) MACRS Annual Year Cost value Depreciation 1 15,000,000 0.200 3,000,000 2 15,000,000 0.320 4,800,000 3 15,000,000 0.192 2,880,000 4 15,000,000 0.115 1,725,000 5 15,000,000 0.115 1,725,000 14,130,000 The prior accelerated cost recovery system had been the product of the economic recovery tax act of 1981. Also, the MACRS was a complete going away from the prior tax depreciation procedures instituted by fundamentals of financial accounting. Meaning, the prior depreciation methods took cognizance of including the salvage value or scrap value of the assets(Ross, 1996). The prior depreciation methods include the straight line method, the sum of the years digits, the double declining method, the 150 percent declining method, the units of production method, the hours of production used method and tools expense methods among others. This prior system that had been closely similar to the financial accounting depreciation methods has now been changed to mechanical computation called MACRS. Distinctly, the MACRS c) The project's Operating Cash Flows (inflows) (15 marks) Cash inflows Year Cash inflows 1 3,500,000 0.8850 3,097,500 2 4,000,000 0.7831 3,132,400 3 6,000,000 0.6931 4,158,600 4 8,000,000 0.6133 4,906,400 5 12,000,000 0.5428 6,513,600 Total for 5 yrs 33,500,000 21,808,500 Less depreciation 5 yrs 14,130,000 Cash inflows before tax 7,678,500 Tax 40% 3,071,400 Cash inflows after tax 4,607,100 Add back depreciation 14,130,000 Cash inflows 18,737,100 The cash inflow for the first year is 3,500,000 multiplied by the present value factor of 1 of .8850 results to cash inflow of 3,097,500. on the second year, the 4,000,000 multiplied by the present value factor of 1 of .78831 results to cash inflow of 3,132,400. on the third year, 6,000,000 multiplied by the present value factor of 1 of .6931 results to cash inflow of 4,158,600. On the fourth year, the 8,000,000 multiplied by the present value factor of 1 of .6133 results to cash inflow of 4,906,400. on the fifth year, 12,000,000 multiplied by the present value factor of 1 of .5428 results to cash inflow of 6,513,600. The total cash inflows is then deducted the depreciation expense based on MACRS amounting to 14,130,000 to come up with a cash inflow subject to tax of 7,678,500. Then this amount is multiplied by the 40 percent tax amounting to 3,071,400 to come up with the cash inflows after tax if 4,607,100. Then the depreciation expense based on MACRS is added back to come up with the cash inflows after tax of 18,737,100. d) The project's Terminal Cash Flows (15 marks) Scrap value 5th yr 4,000,000 0.5428 2,171,200 The scrap value for the fifth year of 4,000,000 is multiplied by the present value of 1 for five years at .5428 is 2,171,200. This amount is used as additional cash inflow that will help pay for the cost of investment amounting to 15,000,000. Clearly, the company needs to generate cash inflows that is more than the capital investment here. e) The project's NPV and IRR; in addition, explain if and why the project is acceptable under the NPV and IRR and comment on why might the two methods produce or not the same results. (30 marks) Cash inflows Year Cash inflows 1 3,500,000 0.8850 3,097,500 2 4,000,000 0.7831 3,132,400 3 6,000,000 0.6931 4,158,600 4 8,000,000 0.6133 4,906,400 5 12,000,000 0.5428 6,513,600 Total for 5 yrs 33,500,000 21,808,500 Less depreciation 5 yrs 14,130,000 Cash inflows before tax 7,678,500 Tax 40% 3,071,400 Cash inflows after tax 4,607,100 Add back depreciation 14,130,000 Cash inflows 18,737,100 Cost of investment 15,000,000 Net present value 3,737,100 18,737,100. This amount is then deducted from the cost of investment of 15,000,000. The result is a net present value of 3,737,100 as shown above. IRR = Cost = 15,000,000 Annual Cash inflows 3,747,420 = 4.00 = 8 percent The internal rate of return is computed by dividing the cost of capital amounting to 15,000,000 by the average annual cash inflow of 3,747,420. Then, this internal rate of return of 4.00 represents the ____ percent internal rate of return. The internal rate of return is computed by dividing the cost of investment amounting to 15,000,000 by its average annual cash inflows for the five years at 4,361,700 to arrive at the internal rate of return factor amount 3.44. Then, looking at the present value factor for 1 for five years, we arrive at the fourteen percent cost of capital rate. This shows that the cost of capital here of fourteen percent is glaringly higher than the original cost of capital of only thirteen percent. f) Given that the company usually accepts projects that have a payback period between 1 and 4 years, is this project acceptable Yes, because the assets have a useful life of five years and the cost can be recovered in four years or less. If a discounted payback period is used is the project still acceptable Present value MACRS Cashflow Year Cash inflow Depreciation before tax 1 3,097,500 3,000,000 97,500 2 3,132,400 4,800,000 (1,667,600) 3 4,158,600 2,880,000 1,278,600 4 4,906,400 1,725,000 3,181,400 5 6,513,600 1,725,000 4,788,600 Net of 40% tax Cash flows Add back Cash Year after tax Depreciation inflow Cash flow 1 58,500 3,000,000 3,058,500 3,058,500 2 (1,000,560) 4,800,000 3,799,440 6,857,940 3 767,160 2,880,000 3,647,160 10,505,100 4 1,908,840 1,725,000 3,633,840 14,138,940 5 2,873,160 1,725,000 4,598,160 18,737,100 15,000,000 14,138,940 861,060 861,060 = 0.05 18,737,100 The above computation shows that the cash inflows that were discounted for four years amounting to 14,138,940. Then, 15,000,00 is deducted 14,138,940 to arrive at 861,060. Then, this amount is divided by the remaining cash inflow for the 5th year. The result is five (5) percent. In the end, the payback period under discounted cash flow is 4.05 years. Why the payback period is considered an 'inferior' method of investment appraisal when compared to NPV and IRR Explain. (20 marks) Because the Net present value shows whether the total cash inflows is more than the cost of investment. In this case, the net present value is negative because the total cash inflow is less than the cost of investment. Also, the internal rate of return shows that it takes a higher rate of 18 percent for the company recover the cost of investment of 15,000,000. And also, the payback period only refers to the number of years need to recover the initial cash outlay. This factor only measures how quickly the project will return its original investment. Further, it deals only with cash flows and not accounting profits. The payback period does not take into consideration the time value of money. Meaning, payback period does not include in its analysis the discounting the cash inflows back the present year when the investment of a large amount in either a factory equipment or an entire factory is transacted or takes into effect. Evidently, the net present value and then internal rate of return takes cognizance of the time value of money by taking into consideration the decrease in the value of money. Meaning the value of money decreases as the time money goes further into the future. For example, the present value of our 15,000,000 investment has a declining factor from .8850 on the first year, .7831 on the second year, .6931 on the third year,.6133 on the fourth year and .5428 on the fifth year. Thus, payback period is a less favorable analytical tool in capital budgeting decisions where it is not a joke invest large sums of money because of the accompanying high risk of losing invested money. CONCLUSION The above discussion shows how MACRS increases the cash inflows because the depreciation expense starts with a large amount and decreases every year until the fifth and last year. Clearly, the investment in the new platform and machine amounting to 15,000,000 is a good decision because the total cash inflows after tax and after adding back depreciation expenses is more than the cost of investment. REFERENCES: Weston, J., Brigham, E., 1993, Essentials of Managerial Finance, London, Dryden Press, P951 Brigham, E., Gapenski, L., 1985, Financial Management, London, Dryden PressP1119 Ross et al., 1996, Essentials of Corporate Finance, London, Irwin Press P509 Ross et al., 1996, Corporate Finance, Irwin Press, London, Irwin P 886 Read More