Assignment 2: Estimating Cash Flows For Your Company
Assignment 2 Estimating Cash Flowsassume That Your Company Is Conside
Assume that your company is considering the replacement of an automated milling machine with one of the new machines offered by three different manufacturers. Each of the three machines under consideration is expected to have an economic life of five years and will result in greater daily production capacity and therefore increased sales volume. The increased volume will require an increase in working capital during the first year to a level that will remain constant until the end of the five years. The decision of which specific machine to select will depend on a net present value analysis. The old machine has reached the end of its estimated useful life and can be sold at the salvage value that was projected when the machine was first installed.
Listed below are factors that may be essential for inclusion when estimating project cash flows. The factors may be required to correctly calculate either the initial investment, the operating cash flows, or the terminal value that would be analyzed to determine the net present value of the project. It is also possible that certain factors could be used in more than one of the three categories of cash flow. Another possibility is that the factor listed is not relevant to cash flow estimation for this specific scenario. Your task is to identify whether the factor would be included in the calculation for the initial investment, or the operating cash flow, or the terminal value, or is not relevant to this decision.
You must also explain whether failure to appropriately include the factor in the calculation would result in overstating or understating the net present value of the project. Factors that are not relevant to the NPV calculation should not be included on any slide.
Factors to consider:
- Purchase price of capital asset
- Incremental annual depreciation expense
- Total company sales revenue
- Cash realized from sale of the old machine at its estimated salvage value
- Interest on the loan used to finance the asset purchase
- Total annual depreciation expense
- Increase in working capital
- Decrease in working capital
- Total net income before tax
- Incremental net income before tax
- Marginal income tax rate
- Investment tax credit
- Cost of shipping and installing the new equipment
Directions: You are to develop a PowerPoint presentation. Create 1-3 slides for factors used to determine initial investment, 2-5 slides for factors used in operating cash flow estimates, and 1-3 slides for factors used in the terminal value estimate. Indicate on the slides whether failure to appropriately include the factor would result in overstating or understating the NPV. Provide additional explanations or comments in the speaker notes for each slide, applying APA standards for writing style.
Paper For Above instruction
The strategic decision to replace an aging milling machine involves a comprehensive financial analysis centered on estimating cash flows through the net present value (NPV) method. This process encompasses identifying relevant factors for initial investment, operating cash flows, and terminal value, and understanding their influence on the accuracy of the NPV calculation. Proper inclusion or exclusion of these factors is critical as misestimations can lead to biased investment decisions, either overstating or understating the project's value.
Initial Investment Factors
Purchase Price of Capital Asset
The purchase price of the new machine is fundamental in determining the initial investment outlay. It constitutes the capital expenditure required to acquire the asset and is included in the initial cash flow calculation. Overlooking this figure would understate the initial cash outlay, leading to an overstated NPV, as the capital costs would be understated, making the investment seem more favorable than it truly is.
Cost of Shipping and Installing the New Equipment
The costs associated with shipping and installing are integral to the total capital expenditure. These costs are necessary to bring the asset into operational condition. Omitting these costs would result in an undervaluation of the initial investment, hence overstating the NPV and potentially leading to a misguided investment decision.
Cash Realized from Sale of the Old Machine at Its Estimated Salvage Value
The salvage value of the old machine is relevant because it offsets part of the initial cash outflow. It is an inflow at the project's start, reducing the net initial investment. Failure to account for this inflow would overstate the initial cash outlay and consequently underestimate the NPV, possibly deterring a beneficial investment.
Interest on the Loan Used to Finance the Asset Purchase
Interest payments are generally considered financing costs and are excluded from project cash flows. They are accounted for in the financing structure rather than project evaluation. Including interest costs in project cash flows would distort the valuation, likely understating the NPV, because it would double-count financing expenses.
Investment Tax Credit
If available, the investment tax credit effectively reduces the net initial investment through tax savings. Proper inclusion of this credit would decrease the outlay, leading to a higher NPV. Ignoring it would result in an understated NPV, undervaluing the project’s attractiveness.
Operating Cash Flow Factors
Incremental Annual Depreciation Expense
Depreciation is a non-cash expense; its inclusion affects taxable income and thus impacts tax payments, influencing operating cash flows. While depreciation itself does not result in cash flow, it provides tax shields. Omitting this effect would underestimate tax savings and thus underestimate operating cash flows, undervaluing the project.
Total Company Sales Revenue
This figure reflects the additional revenues expected from increased production capacity. It is a key component of operating cash inflows. Failure to incorporate this would understate cash flows and undervalue the project, potentially causing missed investment opportunities.
Incremental Net Income Before Tax
This measures the additional profit generated by the project before taxes. It is relevant for calculating operating cash flows after adjusting for non-cash expenses. Excluding it would underestimate the project’s profitability and cash flows, leading to an undervaluation of NPV.
Marginal Income Tax Rate
The tax rate determines the tax impact on incremental income, affecting after-tax cash flows. An accurate application results in correct tax shield calculation. Misestimating the tax rate would skew cash flow projections, overstating or understating NPV depending on the direction of error.
Increase in Working Capital
Additional working capital is a cash outflow at project initiation. Its recovery occurs at terminal. Underestimating this would overstate NPV by ignoring the cash outlay; overestimating would understate NPV by including excessive cash flows.
Decrease in Working Capital
Recovery of working capital at project end is an inflow. Omitting this would underestimate terminal cash flows, understating the project value.
Terminal Value Factors
Salvage Value of the Machine
The salvage value at the end of the machine’s useful life contributes as a terminal cash inflow. Correct inclusion ensures accurate valuation of residual benefits. Excluding it understates project terminal cash flow, undervaluing the project.
Total Depreciation Expense
While depreciation affects tax payments during the project, it is a non-cash expense and does not directly impact terminal value calculations. Its inclusion is unnecessary here.
Other Factors not Relevant
Interest on loans is financing-related and should be excluded from project cash flows. Similarly, total company sales revenue and net income before taxes are indirect indicators; only incremental cash flows matter in NPV calculations.
Conclusion
Accurate project valuation requires careful selection of relevant factors for initial investment, operating cash flows, and terminal value. Proper inclusion ensures correct estimation of NPV, guiding sound investment decisions. Misestimations—either omitting critical cash inflows or inflating outflows—can lead to biased outcomes, potentially resulting in over- or under-investment.
References
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