The Main Focus When Making Capital Budgeting Decisions Finance Essay
Capital budgeting is the process by which the financial manager decides whether to invest in any asset or specific capital projects. It is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants or products, and research development projects are worth pursuing. Most companies have many different projects but all of them cannot actually be funded, hence managers must carefully select those projects that promise the greatest future return by taking relevant managerial decisions after the analysis of capital budgeting techniques.
We know that liquidity of a business is determined by its Cash flow. The movement of money in and out of the business is regarded as the cash flow. Managing cash flow is vitally important in the smooth running, success and survival of a business. Having completed the cash flow forecast, the business can see when there might be times when it might be in difficulties and thereafter put in place a strategy to deal with the problem. Therefore the most preferred method while making any managerial decisions should be using the incremental cash flows and discounting them to reflect the time value of money. A positive incremental cash flow indicates that the company's cash flow will increase with the acceptance of the project and therefore an organization should spend some time and money investing in the project.
On the other hand, Reinaldo should also be focusing on the Accounting Profits which is the difference between total revenue and explicit costs. Reinaldo should make sure that the project is meeting the organizations required rate of return. He should forecast or project the impact on the company’s future financial statements by calculating and understanding the effect on the accounting profits resulting from the capital expenditure. Considering the project will be terminated in 5 years, he should also focus on the Incremental profits i.e. the profit gain or loss associated with a given managerial decision. As long as the Incremental profit is positive i.e. the incremental revenue is more than the incremental cost, the total profit increases and vice-versa.
2) How does depreciation affect free cash flows?
In accounting, an expense recorded to allocate a tangible asset's cost over its useful life is known as Depreciation. Because depreciation is a non-cash expense, it increases free cash flow while decreasing reported earnings and does not directly affect the cash flow of a company.
Depreciation = Cost – Residual value / Life
Depreciation does not affect cash flow statement as depreciation is not a cash expense rather it is just a treatment to dispose off the value of asset according to useful life of asset and the cost of asset is already shown in cash flow statement when asset is purchased.
However, depreciation recognized for tax purposes will affect the cash flow of the company, as it will reduce taxable profits. Since the focus of analysis is cash flow, the importance of depreciation expense arises from the fact that depreciation expense can be used to reduce future tax liabilities through the reduction of taxable income by an amount equal to depreciation expense. When depreciation expense is tax deductible, cash flow increases because of the Tax savings because depreciation expense reduces taxable income and therefore the resulting tax liability.
3. How do sunk costs affect the determination of cash flows?
A cost that has been incurred and cannot be reversed is commonly referred to as Sunk cost or Embedded cost. Ex- A worn-out piece of equipment bought several years ago is a sunk cost because the cost of buying it cannot be reversed. Since we can’t undo the cash flow outflow, only future costs are relevant to decision making because only future cash disbursements can be controlled. These costs are incurred before an activity hence it represents an outflow in the cash flow statement. Therefore it is implied that a huge sunk cost can make an investment irreversible and higher is the sunk cost, higher will be its effect on the cash flow or vice-versa.
4. What is the project’s initial outlay?
It is the cost of entering into a project which includes the cash required to acquire the new equipment or build the new plant less any net cash proceeds from the disposal of the replaced equipment (if any). The initial outlay also includes any additional working capital related to the new equipment. Only costs that occur at the beginning of the project are included as part of the project’s initial outlay. Any additional working capital needed or no longer needed in a future period is accounted for as a cash outflow or cash inflow during that period.
The initial outlay for Reinaldo Products for this particular project will include the following:
Cost of new plant & equipment
Shipping and installation costs
Initial working capital requirement
5. What are the differential cash flows over the project life?
Differential Cash flow is the net free cash flow of a project after taking into account the changes in its operating expenses, taxes and depreciation and revenue. The Differential cash flows of this particular project over the life of the project i.e. 5 years can be seen in the below table.
Differential Cash Flow
Table showing the working/calculations of the Differential Cash Flow:
Workings of Differential Cash Flow
Selling price per unit
Variable cost per unit
(-) Variable cost
(-) Fixed cost
(=) Operating CF
(-) Incremental WC **
(-) Capital Investment
Differential Cash Flow
Working capital required
WC 1 - WC 0
WC 2 - WC 1
WC 3 - WC 2
WC 4 - WC 3
WC 5 - WC 4 - Liquidated WC
6. What is the terminal cash flow?
Cash flows resulting at the end or termination of a project, without including the operating cash flows are termed as Terminal cash flow. The terminal cash flow comprises of the salvage value of the plant and equipment deducting the tax from the termination of the assets and the net working capital recovered. In this particular investment the salvage value of the plant & equipment is $0 after the end of 5 years, but there is liquidation of the working capital amounting to $2,400,000.
Therefore the Terminal cash flow for this investment will be $ 2,400,000 as highlighted in the table showing the workings of differential cash flow above.
7. A cash flow diagram for this project.
Cash Flow is a statement which represents the Cash inflow and outflow for a particular period to determine the cash flow in financing, operating and investing activities.
8. What is the net present value?
The present value of an investment's future net cash flows deducting the initial investment is known as the Net present value or (NPV). It compares the value of a dollar today to the value of that same dollar in the future, because a dollar today is worth more than a dollar tomorrow considering inflation and returns into account. Any investment rule that does not recognizes the Time value of money cannot be sensible. It is solely dependent on the forecasted cash flows from the project and the opportunity cost of capital. It helps in selecting or making appropriate decisions when the firm has multiple choices. If the net present value of a prospective project is positive or greater than the other project, it should be accepted and if it is negative or lower when compared to other options, it should probably be rejected because cash flows will also be negative. However, if net present value is 0 i.e. neither positive nor negative, which implies that a project implies no monetary value, a decision to select or reject that particular proposal should be made considering other factors into account like strategic positioning, risk appetite etc.
Therefore it can be said that Net present value expresses whether a particular project or investment will increase the firm’s value by considering all the cash flows, risk of future cash flows and the time value of money. In consideration with this particular project or investment at Reinaldo products the Net present value is positive as per the calculation mentioned below.
Net Present Value
9. What is the internal rate of return?
The Internal rate of return is the discount rate that gives a net present value of zero. It is the average annual return earned through the life of an investment and is computed in several ways. The internal rate of return is an important calculation used frequently to determine if a given investment is worthwhile. Depending on the method used, it can either be the effective rate of interest on a deposit or loan, or the discount rate that reduces to zero the net present value of a stream of income inflows and outflows. An investment is generally considered worthwhile if the internal rate of return is greater than the return of an average similar investment opportunity, or if it is greater than the cost of capital of the opportunity. The internal rate of return or the IRR method will usually result in the same decision as the net present value method for non-mutually exclusive projects in an unconstrained environment. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR may select a project even with a lower net present value.
One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR and therefore, the actual rate of return is almost certainly going to be lower.
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