I am carrying out capital budgeting for Zeta Widgets inc. The analysis below shows a decision on whether to replace a machine or remain with the old one. The method of analyzing is the net present value of a company.
Table for cashflows.
Therefore NPV = (1,000,000)+ 440,000 + 440,000 +440,000 +440,000 + 440,000
(1.0925)1 (1.0925) 2 (1.0925)3 (1.0925)4 (1.0925)5
(1,000,000) + 402,746 + 368,646+ 337,433+ 308,863+ 282,712 = 700,400
The company should undertake the project as it has a positive Net present value of $ 700,400 this project will be of great value to the company. The calculation of net present value is shown above with the following assumptions;
- no corporate taxes
- Depreciation adds no cash inflows or outflows.
- The disposal of the new machine will be done at the same period with when the new one is being bought.
If the above assumptions are held the present value will be $ 700,400. this will increase the shareholders value thus a good project to be undertaken.
The main features and complexities of capital budgeting
Capital budgeting involves the decision making for long-term projects or investments for a company. It involves the for following decision making model:
- identification of objectives
- search for investment opportunities
- identify states of nature
- list possible outcomes
- Measure payoffs
- select investment projects
- obtain authorization and implement projects
- review capital investment decisions.
The effects of inflation on future cash flows and the required rate of return
Always the discount rate of return has a required rate of return on a risk less investment plus the risk premium that is associated with the project risk. Inflation affects both the risk free rate and the risk premium. In order for one to incorporate inflation in the future, cash flows, the interest rate has to be adjusted for inflation. Fisher proposed the following formula for adjusting the required rate of return.
(1+nominal rate of return)= (1 + real rate of interest) x (1 +expected rate of inflation)
Using the above rate of return as an example and the inflation rate of is 8%. then applying the fisher equation it would be
(1+0.0925)(1+0.08)= 1.1799
The nominal rate of return would be 17.99%. This means the shareholders who were earning at 9.25 for every 100 before inflation for the time value of money will now earn 17.99 for every 100. if the return is less than that then they will be loosing.
Inflation also affects the future cash flows. Take for instance; assume that you expect a cash flow of 1000 in one year’s time the rate of inflation remains at 8% as used above. The expected cash flow will be 1080 instead of the expected. However the investors will not be better off than when receiving 1000 without inflation. If adjust the above scenario/case the net present value will be
Capital budgeting under uncertainty of cash flows
Uncertainty exists where there are several possible outcomes, but there is little previous information or statistical evidence to enable the possible outcomes to be predicted. There many methods of handling uncertainty this includes (1) probabilities; this is the likelihood that an event is will occur for example using the above data given and assuming that the probabilities of having 440,000 per year is 70% and probability of having 500,000 is 30%.
Then the cash flows will be as follows
The cash flows that will be subjected to measure NPV analysis will be 452,000.
From the probabilities that some cash is likely to be earned then standard deviations is used to measure dispersion of the probabilities.
References
Christofferson P; (2003) Elements of Financial risk Management; Elsevier.
Givens C., (2002); More Wealth without Risk, Mc GrawHill.
Lindsay R; (1967) Financial Management, An Analytical Approach; R.D Irwin.
Seitz N; (2004) Capital Budgeting and Long-term financing Decisions; Thomson Learning.