Capital Budgeting:Net present value,IRR,sensitivity analysis
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Using data in the attached excel file, respond to these:
Should the company focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows,
incremental profits, total free cash flows, or total profits?
b.
How does depreciation affect free cash flows?
c.
How do sunk costs affect the determination of cash flows?
d.
What is the projects initial outlay?
e.
What are the differential cash flows over the projects life?
f.
What is the terminal cash flow?
g.
Draw a cash flow diagram for this project?
h.
What is its net present value?
i.
What is its internal rate of return?
j.
Should the project be accepted? Why or why not?
k.
In capital budgeting, risk can be measured from three perspectives. What are those three measures of a projects risk?
l.
According to CAPM, which measurements of a projects risk is relevant? What complications does reality introduce into the CAPM view of risk, and what does that
mean for our view of the relevant measure of a projects risk?
m.
Explain how simulation works. What is the value in using a simulation approach?
n.
What is sensitivity analysis and what is its purpose?
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Solution Summary
The problem deals with capital budgeting topics including: net present value, internal rate of return, cash flow analysis etc.
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We are considering the introduction of a new product. Currently we are in the 34% marginal tax bracket with a 15% required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad project, be terminated. The following information describes the new project
Cost of a new plant and equipment $7,900,000
Shipping and installation cost $100,000
Year Units Sold
1 70,000
2 120,000
3 140,000
4 80,000
5 60,000
Sales price per unit $300/unit in years 1 through 4, $260/unit in year 5
Variable cost per unit $180/unit
Annual fixed costs $200,000
Working-capital requirements:
There will be an initial working-capital requirement of $100,000 just to get production stared. For each year, the total investment in net working capital will be equal to 10% of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, the decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.
The depreciation method.
Use the simplified straight-line method over 5 years. Assume that the plant and equipment will have no salvage after 5 years.
A.
Should the company focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows, incremental profits, total free cash flows, or total profits?
Capital budgeting is the use of techniques that would help a firm evaluate whether a project is acceptable or not. The process involves the use of cash flows for decision-making. Accounting profits are never used in evaluating decisions primarily because of the use of the accrual concept in income determination.
In evaluating a project, the firm would be interested in the incremental cash flows associated with each project.
B.
How does depreciation affect free cash flows?
Depreciation is an accounting technique, which allows a firm to apply the costs, of asset purchases, on its income statement. ...
Education
- B. Sc., University of Nigeria
- M. Sc., London South Bank University
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