Capital Budgeting
Presentation
Investment Opportunity
Analysis
Type your name Net Cash Flow For Second Year When There is No Depreciation
Net cash inflow is the difference between a company’s cash inflow and outflow (expenses). If all the expenses are same as describe in the scenario except there is no depreciation, the correct net cash inflow for the second year would be $525,000[(3,100,000-2,400,000) (1-0.25)].
This change in cash flow due the tax shield on depreciation which lessens the tax liability which is is not there. The depreciation itself is not a cash flow but reduces the taxes that must be paid, shielding income from taxation (Peterson & Fabozzi, 2002).
Depreciation has no impact on cash flows if there is no tax but if there is tax, the depreciation expense provides tax shield. As in second year the cash flow is higher by $629,375$525,000=104,375 which is equal to tax saving on depreciation, $417,500*0.25=104,375
Net Present Value
NPV method is most dependable than other investment evaluation techniques since it accounts for time value of money. The NPV of a capital budgeting project is the dollar amount of the change in the value of a firm as a result of undertaking the project (Gallagher & Andrew, 2007).
The decision rule applicable to NPV as an investment criterion is to consider all projects with positive NPV as acceptable and projects with negative NPV as rejected.
At cost of capital of 12%, the sum of discounted cash inflow exceeds the cash outflow by $ 82,078 and as NPV is positive the project should be accepted. Positive NPV suggests that the project will profit if accepted and therefore it’s a good investment for Entrepreneur D.
Internal Rate of Return
Internal rate of return is an investment profitability measure that is closely related to net present value (McAllister, 2009). It is used to evaluate the attractiveness of a project under study. IRR values the time value of money, measuring time value of cash flows in all prospect giving equal weight to all cash flow.
A project is chosen when the IRR is higher than the cost of financing. The larger the difference between the financing cost and the IRR, the more attractive the project becomes.
IRR for the project under study is 12.59% which is more than 12% cost of capital therefore Entrepreneur D should make the investment. The excess
IRR hints that the project will generate positive NPV.
Difference between the Accounting Rate of Return and
Internal Rate of Return
The IRR for this capital investment stand at 12.59% where as accounting rate of return stand at 49.97%. The difference is because IRR focuses on the value of cash flows and ARR doesn’t. In so doing, the internal rate of return considers the time value of money. This signify that cash flows brought in afterwards in the investment have less value than cash flows brought in early in the outlay. The accounting rate of return does not focuses on values of future cash flows and thus does not discount the value of cash flows.
Rather, the ARR focuses on yearly operating income, not cash flows, taking into account non cash expenses such as depreciation expenses. In
ARR the annual operating income is compared to the average amount invested, focusing on the profitability of the initial investment over it's life.
While ignoring the time value of money and taking into account depreciation expense, it is likely to have a higher accounting rate of return than internal rate of return, which is exactly what is found with this investment proposal.
Relative Importance of Unadjusted Payback Period
The payback period is of use from a risk analysis viewpoint, since it gives a fast picture of the extent of time that the original investment will be at risk. The non discounted cash flows from every year are added together from each year and month until the cash flows are equal to the original outlay.
In this case, the payback period for project is 5 years and 2 months. With cash flows and net income rising
