(a) You are the financial manager of a very profitable firm, which is currently evaluating a new, large investment project at the start of 2020. The project involves the acquisition of a plant, which requires an initial outlay of £300 million. The project's investment horizon is six years. Over this period, the initial capital investment in the plant should be fully depreciated. Despite this, it is expected that at the end of the project (after six years) the taxable salvage value of the plant will amount to £50 million. The project requires an initial (at the start of 2020) working capital investment of £30 million, which should be recovered in full at the end of 2025. Your accountants have put together the following projections on expected sales and cash flows, and information on the cost of capital of the company: Sales EBITD Depreciation EBIT Tax expense EBIAT Table 1. Sales and cash flow projections 2022 140 80 (50) 30 (6) 2020 120 60 (50) 10 (2) 8 Risk-free Rate (Rf) Project Cost of Debt (Rd) Market Risk Premium 2021 135 75 (50) 25 (5) 20 24 Marginal Corporate Tax Rate (Tc) Asset Beta of comparable companies Table 2. Cost of capital 1% 4% 6% 2023 125 65 (50) 15 (3) 20% 0.8 12 2024 120 60 (50) 10 (2) 8 2025 110 50 (50) 0 0 0 Required: Carry out the following calculations, always assuming that cash flows occur at the end of their respective years: (i) Estimate the NPV of the investment project at the start of 2020 if it is 100% financed with equity. Comment on your findings. (ii) Use the WACC method to estimate the NPV of the investment at the start of 2020 assuming that it is financed 40% with equity and 60% with debt and that the financing structure of the project does not change over the life of the project. Comment on your findings. (iii) Show how you could alternatively compute the NPV of part (ii) above by using the APV method rather than the WACC method. (iv) Calculate the NPV of the investment at the start of 2020 assuming that your firm initially borrows £120 million and then pays down the debt at a rate of £20 million per year. Assume that interest payments can always be used to offset the company's taxable profits over the life of the project. Comment on your findings.
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
Trending now
This is a popular solution!
Step by step
Solved in 5 steps with 8 images
