You have been asked to provide an NPV analysis of a proposed project which would generate cash flows over a period of 4 years. In the first year, revenues are estimated at $8 million and the expenses at $2 million. Both revenues and expenses are expected to increase by 5% each year for the following 3 years. The project requires an initial investment of $20 million in machinery. Machinery can be depreciated for tax purposes using the straight-line method over 4 years. After four years we expect that the company can sell the machinery for $15 million. The data are based on the output of an initial rearch study (R&D) that the company performed last year. The R&D that determined that the project is technically feasible had a cost of $1 million. The proposed project requires to keep a working capital (level) of 10% of next year's rev- enues. The opportunity cost of capital for the investment is 15%. The firm's tax rate is 35%. Please compute the NPV and IRR and make a recommendation on whether the project should be undertaken or not.
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.
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