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Capital Budgeting Reliance on Analysis of Cash Flows

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1. Why does capital budgeting rely on analysis of cash flows rather than on net income?

2. What is normally used as the discount rate in the net present value method?

3. Have you ever heard of the replacement decision?

4 Does capital budgeting deals with actual dollars?

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1. Why does capital budgeting rely on analysis of cash flows rather than on net income? could you provide an example to illustrate the (your) points.

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.
Decisions like the change in the methods of sales distribution, or an advertisement campaign or research and development programs have long-term implications for the firm's expenditures and benefits, and therefore, they should also be evaluated as investment decisions. Several different procedures are available to analyze potential business investments. Some concepts are better than others when it comes to reliability but all provide enough information to get the general scope of the investment. The five procedures that provide useful information are the Net present Value (NPV), the Payback Rule, the Average Accounting Return (AAR), the Internal Rate of Return (IRR), and the Profitability Index (PI). These ...

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Cost of Capital, Capital Structure, and Capital Budgeting Analysis

Purpose of the project:
In this project, you are supposed to be a financial manager who determines the cost of debt, cost of preferred stock, cost of common equity, capital structure, and the weighted average cost of capital (WACC) for a Phizer (PFE). You will use the estimated WACC as the discount rate to conduct capital budgeting analysis for a hypothetical project (the information given below) that is under consideration by Phizer (PFE), and decide whether the project should be accepted.

(1) Compute Weighted Average Cost of Capital (WACC)
- Estimate the firm's before-tax and after-tax component cost of debt; (Note: If the information about the current corporate tax rate is not available, you need to estimate the tax rate based on the historical tax payments).
- Estimate the firm's component cost of preferred stock;
- Use three approaches (CAPM, DCF, bond-yield-plus-risk-premium) to estimate the component cost of common equity of the firm.
- Calculate the firm's weighted average cost of capital (WACC) using market-based capital weights.

(2) Cash Flow Estimation
- Assume that Phizer (PFE) is considering a new project. The project has 8 years life. This project requires initial investment of $300 million to construct building and purchase equipment, and $20 million for shipping & installation fee. The fixed assets fall in the 7-year MACRS class. The salvage value of the fixed assets is $15 million. The number of units of the new product expected to be sold in the first year is 2,000,000 and the expected annual growth rate is 10%. The sales price is $300 per unit and the variable cost is $220 per unit in the first year, but they should be adjusted accordingly based on the estimated annualized inflation rate of 2.8%. The required net operating working capital (NOWC) is 12% of sales. Please use the corporate tax rate that you obtained in Step (1) for the project. The project is assumed to have the same risk as the corporation, so you should use the WACC you obtained from prior steps as the discount rate.

- Compute the depreciation basis and annual depreciation of the new project.
- Estimate annual cash flows for the 8 years.
- Draw a time line of the cash flows.

(3) Capital Budgeting Analysis
- Using the WACC you obtained from in Step (1) as the discount rate for this project, apply capital budgeting analysis techniques (NPV, IRR, MIRR, PI, Payback, Discounted Payback) to analyze the new project.
- Perform a sensitivity analysis for the effects of key variables (e.g., sales growth rate, cost of capital, unit costs, sales price) on the estimated NPV or IRR in order to demonstrate the sensitivity of the model. The Scenario analysis of several variables simultaneously is encouraged, but not required.
- Discuss whether the project should be taken and summarize your report.

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