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Capital Budgeting

Capital Budgeting. Anne E. Sobala Western Governor’s University September 11, 2012. Qn 1. Cash Flow and Depreciation. Net Cash Flow = Net Income + Depreciation + Amortization (Brigham & Ehrhardt, 2010) Taxable Income is overstated and Net Income is reduced due to this effect.

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Capital Budgeting

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  1. Capital Budgeting Anne E. Sobala Western Governor’s University September 11, 2012

  2. Qn 1. Cash Flow and Depreciation • Net Cash Flow = Net Income + Depreciation + Amortization (Brigham & Ehrhardt, 2010) • Taxable Income is overstated and Net Income is reduced due to this effect. • Further reduction in Net Cash Flow will occur because, normally, depreciation is added back in the calculation of Net Cash Flow. • Therefore, the value of Net Cash flow appears lower if not corrected for inflation. • For Year 2, it will be less by $398,750 ( the value of depreciation) and the additional impact of tax. • The value would be $624688-$398750=$225,938

  3. Qn. 2. Net Present Value Analysis • Investment projects that have a positive net present value are viable in economic terms (Booker, 2006) • The Net Present Value of the investment project is positive i.e. $346,250. • This means that by the end of the 8th year, the investment will have generated a positive value of $346,250. • Based on this consideration, it is recommendable that the project should be implemented. • A positive value of NPV adds to capital with time and corrects for depreciation. • Projects with negative values of NPV should not be implemented.

  4. Qn.3. Internal Rate of Return • IRR is a preferred viability assessment value for investments. • Reason: It measures the effective interest rate of an investment i.e. interest earned on capital. • An investment project with a positive NPV has its IRR higher than the weighted average cost of capital (in this case 12%). • The IRR for the project is 12.9% • IRR is a more preferred evaluator of investment options. • Recommendation: The is a viable because its IRR is higher than WACC.

  5. Qn 4. Accounting Rate of Return Vs Internal Rate of Return • IRR for the project is12.9% while the AAR is 22.1 % • AAR is higher because IRR does not take into account the net percentage of profit, while ARR does. • IRR is adjusted for time while ARR is not sensitive to the time value of money. • IRR, therefore, gives a more predictive evaluation of prospective investment. • IRR is based on current values of cash inflows while ARR is based on profits.

  6. Qn. 5.Payback Period • Payback period is important in determining whether capital investment will be recovered within the lifespan of the project • In this case, the payback period is 4 years and 9 months. • This period is less than the 8 years which is the project’s life span. • Recommendation: Project should be implemented because it will pay back investment within the project period. • Unadjusted Payback time, does not take into account time value of money hence may not provide a good judgment of the project’s potential • It also does not give an idea of the cash flows after the payback period of the investment.

  7. Qn. 6. Weighted Average Cost of Capital (WACC) and NPV • WACC is a measure of the cost of each unit of money relative to time. • WACC assumed for this project is 12% • NPV adjusts cash flows for the time value of money • Therefore, Weighted Average Cost of Capital measures the value of a project relative to WACC.

  8. Qn. 7. WACC and IRR • In assessing the viability of the project a comparison of IRR and WACC is done. • If WACC is higher than IRR then the investment project should not be implemented • This is because the project would not be adding value to its capital. It will be depreciating in value • Projects are viable only if they show a positive NPV and a value of IRR higher than the average cost of capital

  9. References • Booker, J. (2006). “Financial Planning Management”. Ontario: CCH • Brigham, E. F. & Erhardt, M. C. (2010). Financial Management: Theory and Practice”. Mason, OH: Cengage Learning • Crundwell, F. K. (2008).”Finance for Engineers: Evaluating and Funding of Capital Projects”. London: Springer- Verlag • Loughran, M. (2011). “Financial Accounting for Dummies”. Indianapolis: Wiley Publishers, Inc. • Plewa, F. J. & Friedlob, J. T. (1995). “Understanding Cash Flow”. New York: Wiley

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