Division leaders in JMI's airplane manufacturing plants have asked for your analysis for replacing old manufacturing equipment for standard planes with faster, more costly new equipment next year. This year, though JMI's innovative S2S-900 has experienced moderate initial success, the total aircraft sales have not been as great as in the past, and cash flow has been uneven in this area.
You have been asked to use sensitivity analysis in planning capital budgeting.
Division leaders want to know what would happen to expected cash flows under different discount rates. Others want to know how net present value of the project will vary according to cash flows different from those forecasted.
Explain exactly how a spreadsheet may be set up to build a net present value model for the equipment decision.
What components would be included in the spreadsheet?
How could you perform sensitivity analysis on the spread sheet? (Do not transmit an actual spreadsheet.)
Build your own spreadsheet for these calculations:
What would happen to expected cash flows under different discount rates?
How will the present value of the project vary according to cash flows different from a set forecast?
Create test numbers to show the effects under varying circumstances.
Discussion of Basic Concepts
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 procedures will help rank the projects from the greatest investment to the worst.
Thus capital budgeting has following characteristics:
The exchange of current funds for future benefits.
The funds are invested in long-term assets.
The future benefits will ...
Thorough explanation and computations given for you. Several references also provided.