You Have Recently Assumed The Role Of CFO At Your Company ✓ Solved

You have recently assumed the role of CFO at your company.

The company's CEO is looking to expand its operations by investing in new property, plant, and equipment. You are asked to do some capital budgeting analysis that will determine whether the company should invest in these new plant assets. The firm is looking to expand its operations by 10% of the firm's net property, plant, and equipment. (Calculate this amount by taking 10% of the property, plant, and equipment figure that appears on the firm's balance sheet.) The estimated life of this new property, plant, and equipment will be 12 years. The salvage value of the equipment will be 5% of the property, plant and equipment's cost. The annual EBIT for this new project will be 18% of the project's cost. The company will use the straight-line method to depreciate this equipment. Also assume that there will be no increases in net working capital each year. Use 35% as the tax rate in this project. The hurdle rate for this project will be the WACC that you are able to find on a financial website, such as Gurufocus.com. If you are unable to find the WACC for a company, contact your instructor. He or she will assign you a WACC rate.

Prepare a narrated PowerPoint presentation that will highlight the following items: Your calculations for the amount of property, plant, and equipment and the annual depreciation for the project; Your calculations that convert the project's EBIT to free cash flow for the 12 years of the project; The following capital budgeting results for the project: Net present value, Internal rate of return, Discounted payback period; Your discussion of the results that you calculated above, including a recommendation for acceptance or rejection of the project. Once again, you may embed your Excel spreadsheets into your document. Be sure to follow APA standards for this project.

Paper For Above Instructions

As the new Chief Financial Officer (CFO) of a company contemplating an expansion through investments in property, plant, and equipment (PP&E), it’s crucial to engage in a thorough capital budgeting analysis. This analysis will assess whether the contemplated investments align with the company's financial health and strategic objectives. Capital budgeting is the process of determining the firm's overall long-term investments and evaluating projects to determine value addition or feasibility. This paper outlines the necessary calculations concerning the investment decision along with a recommendation based on those results.

Calculating Required Investments

To begin, the company's current net property, plant, and equipment figures can be retrieved from its balance sheet. Assuming the total net PP&E is denoted as X, the firm plans to expand by 10% of this amount:

Investment Required = 0.10 * X

Next, if X is, for instance, $1,000,000, then the total new investment becomes $100,000. This investment will be used to acquire the necessary assets whose estimated lifespan is 12 years, with a salvage value set at 5% of the total cost of the new equipment.

Depreciation Calculations

Given the straight-line depreciation method, the annual depreciation can be determined as follows:

Annual Depreciation = (Cost of the asset - Salvage Value) / Useful Life

In this case, if the cost is $100,000 and the salvage value is 5% of $100,000, which equals $5,000, the calculation yields:

Annual Depreciation = ($100,000 - $5,000) / 12 = $7,916.67 (approx.)

EBIT Calculation

With an estimated annual EBIT from this new project set at 18% of the project's cost:

Annual EBIT = 0.18 Cost of Investment = 0.18 $100,000 = $18,000

These figures provide a solid foundation for converting EBIT to free cash flow for the lifespan of the project. The free cash flow can be calculated as follows:

Free Cash Flow = EBIT (1 - Tax Rate) + Depreciation

Assuming a tax rate of 35%:

Yearly Free Cash Flow = $18,000 * (1 - 0.35) + $7,916.67 = $11,700 + $7,916.67 = $19,616.67

Capital Budgeting Results

To evaluate the project’s viability, several capital budgeting metrics are calculated, namely Net Present Value (NPV), Internal Rate of Return (IRR), and Discounted Payback Period.

Net Present Value (NPV)

The NPV formula is as follows:

NPV = ∑(CFt / (1 + r)^t) - Initial Investment

Where CFt = cash flow in year t, r = discount rate (WACC), and t = year number. Assuming the WACC (after searching financial data) is identified to be 10%, NPV calculations based on a cash inflow of approximately $19,616.67 for 12 years require use of the formula to ascertain if the NPV is positive, which would indicate that the project is expected to add value.

Internal Rate of Return (IRR)

IRR can be calculated by finding the rate (r) that makes NPV equal to zero. Using iterative numerical methods (or software tools like Excel), the IRR can be calculated from the cash flows generated, allowing for the comparison against the firm's WACC to ensure the project meets the required return.

Discounted Payback Period

This metric indicates how long it will take to recover the initial investment in present value terms. This requires calculating cash flow discounted back to present value until the cumulative cash flow equals the initial investment tally. A typical hurdle for approving projects is ensuring that this payback period does not exceed anticipated limits set by the company's investment policies.

Discussion and Recommendation

Upon scrutiny of the NPV, IRR, and payback period results, the company's management should deliberate on whether to accept or deny the investment proposal. Generally, a positive NPV and an IRR exceeding the WACC would signal a green light for the project. If the discounted payback period falls within acceptable frames, this would further cement the project as a viable opportunity. Conversely, if the results indicate potential value destruction or excessive risk, withdrawal from the investment might be prudent.

Conclusion

In conclusion, the capital budgeting analysis derived from the data confirms vital insights for the CFO regarding the proposed investments in property, plant, and equipment. An informed decision, bolstered by reliable calculations and metrics, will foster a strategy that aligns both growth and sustainability within the company. Thus, thorough analysis and a clearly articulated recommendation become pivotal in navigating the investment landscape.

References

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• Valuation Resources (2023). Cost of Capital & WACC Calculators. Retrieved from www.gurufocus.com.