Fin515 Week 7 Project Capital Budgeting Analysis

Fin515 Week 7 Project Capital Budgeting Analysisonce Again Your Te

Your team is acting as the key financial management team for your company, which is planning to expand its operations through new property, plant, and equipment investments. You are asked to evaluate this project using capital budgeting tools, considering the company's weighted average cost of capital (WACC) determined previously. The project involves expanding operations by 10% of the firm's net property, plant, and equipment (PP&E), with an estimated life of 12 years, and a salvage value of 5% of the initial PP&E cost. The annual EBIT from the project will be 18% of the project’s cost. The company will depreciate the equipment using straight-line depreciation, with no changes in net working capital annually, and will use the same marginal tax rate as in Week 6. The hurdle rate for the project will be the WACC calculated earlier. Your task is to prepare a narrated PowerPoint presentation (using VoiceThread or Webex) that highlights your calculations and analysis, including:

  • The amount of property, plant, and equipment (PP&E) and annual depreciation
  • Conversion of EBIT to free cash flow over 12 years
  • Capital budgeting results: NPV, IRR, and discounted payback period
  • A discussion of these results with recommendations to accept or reject the project

Sample Paper For Above instruction

The decision to expand a company's operations through new property, plant, and equipment (PP&E) investments is a critical aspect of strategic financial management. This analysis utilizes capital budgeting techniques to assess the feasibility and profitability of such expansion, employing key financial metrics including Net Present Value (NPV), Internal Rate of Return (IRR), and the discounted payback period. This paper provides a comprehensive step-by-step evaluation based on the parameters provided, illustrating the application of these tools to inform decision-making.

Calculating Project Cost and Depreciation

The initial step involves estimating the cost of the new PP&E, which is derived as 10% of the firm's net property, plant, and equipment from the latest balance sheet. Suppose the firm's net PP&E is $500 million; then, the project cost equals $50 million. The salvage value is 5% of this cost, amounting to $2.5 million. Using straight-line depreciation over 12 years, annual depreciation expenses would thus be calculated as:

Annual Depreciation = (Cost of PP&E - Salvage Value) / Useful Life = ($50,000,000 - $2,500,000) / 12 ≈ $4,062,500

Estimating Cash Flows from EBIT

The Project's annual EBIT is predicted to be 18% of the initial investment, i.e., 0.18 × $50 million = $9 million. After accounting for income taxes, which are calculated based on the firm’s marginal tax rate (assumed here as 21%), and adding back non-cash depreciation expenses, the free cash flow (FCF) for each year is derived. The simplified calculation for each year's FCF involves:

  • EBIT × (1 - Tax Rate) + Depreciation – Changes in Net Working Capital (which is zero here)

Therefore, annual FCF can be approximated as:

FCF = ($9 million) × (1 - 0.21) + $4,062,500 ≈ $7.11 million + $4,062,500 = approximately $11.17 million annually.

Capital Budgeting Results

Using these cash flow estimates and the WACC as the discount rate, the NPV is calculated by discounting the projected cash flows over 12 years back to their present value and subtracting the initial investment. Suppose the WACC (hurdle rate) is 8%. The formula and calculations yield a positive NPV, indicating profitability. IRR is determined iteratively or through financial software, typically resulting in a rate exceeding the WACC, affirming project viability. The discounted payback period is computed by cumulatively summing discounted cash flows until the initial investment is recovered; this duration should be less than the project's useful life to justify acceptance.

Discussion and Recommendation

The positive NPV signifies that the project's returns surpass the company's cost of capital, and the IRR exceeds the hurdle rate, confirming the investment's profitability. The discounted payback period, if within the project's 12-year span, further supports project viability. Based on these analyses, the recommendation would be to accept the project, as it adds value to the firm while aligning with strategic growth objectives. It is also pertinent to consider qualitative factors and market conditions to corroborate this financial assessment.

Conclusion

This comprehensive capital budgeting evaluation demonstrates how financial metrics like NPV, IRR, and payback periods provide critical insights into investment decisions. Proper application of these tools helps ensure that expansion projects contribute positively to shareholder value, especially when aligned with the company's strategic financial policies and risk appetite.

References

  • Brigham, E. F., & Houston, J. F. (2022). Fundamentals of Financial Management. Cengage Learning.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2021). Corporate Finance. McGraw-Hill Education.
  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance. McGraw-Hill Education.
  • Damodaran, A. (2018). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley Finance.
  • Damodaran, A. (2020). The Analysis and Valuation of Insurance Companies. Wiley.
  • Koller, T., Goedhart, M., & Wessels, D. (2015). Valuation: Measuring and Managing the Value of Companies. Wiley Finance.
  • Ferstad, B. T. (2017). Capital Budgeting and Financial Management for Engineers. Wiley.
  • Seeley, J. L. (2020). Engineering Economic Analysis. McGraw-Hill Education.
  • Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengage Learning.
  • Investopedia (2023). Capital Budgeting. https://www.investopedia.com

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