Question No. 1 - Statement of the Incremental Cash Flows over 8-Year Period
Based on the given information and data, the following statement is extracted to reflect incremental cash flows for each year accompanied by a table showing calculation of depreciation expense using straight line method:
Question No. 2 - Payback Period (PBP) and Net Present Value (NPV)
Payback Period (PBP)
The period within which the initial investment in project could be recovered represents the Payback Period (PBP). The criteria of making investment decision in case of this capital budgeting technique is that any project that has a Payback Period (PBP) beyond the one “required” by the business is ignored. In the same manner, only those projects are accepted that help an organization recover its initial investment in the best possible time-frame, preferably earlier than what the business requires . For calculating the Payback Period (PBP) of the concerned manufacturing company, the following computations and formula are considered:
For calculating the Payback Period (PBP), following formula is considered:
Payback Period (PBP) = A + (B / C)
Where,
Last period with last negative cumulate cash flow
Absolute value of cumulative cash flow at end of year A
Total cash flow in the following period
Payback Period (PBP) = 1 + (|-$750,000| / $1,500,000)
Payback Period (PBP) = 1 + 0.50
Payback Period (PBP) = 1.50 years
Investment Decision
As the Manufacturing Company’s policy is to reject projects with Payback Period (PBP) beyond Three (3) years, this project should certainly be accepted as it can help the organization recover its initial investment of $1,700,000 within a period of one year and six months or 1.50 years.
Net Present Value (NPV)
It is a capital budgeting technique that determines whether a project is capable enough to create a positive or negative value for an organization. Here, it will demonstrate whether a given project is profitable or not, if pursued at the cost of capital (CoC) of 10% by the manufacturing company .
In case of the Net Present Value (NPV), only those projects with positive NPV are accepted. However, projects with negative NPVs are always ignored or disregarded as they fail to create enough value for the company and its stakeholders. To arrive at a feasible investment decision, the following calculations are considered:
Investment Decision
Based on the above computations, it is found that this particular project, with a factor or cost of capital of 10%, has a positive Net Present Value (NPV) of $1,547,591.13 compared to the initial investment of $1,700,000. Therefore, the manufacturing company should accept this particular project which is also confirmed by the Payback Period (PBP).
Question No. 3 –Influence of Additional Investment in Land and Building on Decisions
The cost of additional investment in land and building incurred by the manufacturing company must be included in the project’s initial investment since such a cost would be regarded as a relevant cash outflow. The whole picture would change resulting in another investment decision. Possibly, the project’s Net Present Value (NPV) of may turn out to be negative causing the managers of the manufacturing company to reject the project. Similarly, as the acquisition cost of land and building increases the initial investment by amount of additional investment, more time would be required by the project to recover the initial investment. Here, Payback Period (PBP) may result in time lag of beyond 3 years and reject the project.
References
Kim, T.-h., Ramos, C., Kim, H.-k., Kiumi, A., Mohammed, S., & Slezak, D. (2012). Computer Applications for Software Engineering, Disaster Recovery, and Business Continuity: International Conferences, ASEA and DRBC 2012, Held in Conjunction with GST 2012, Jeju Island, Korea, November 28-December 2, 2012. Proceedings. Springer.
Vernimmen, P., & Quiry, P. (2009). Corporate Finance: Theory and Practice. John Wiley & Son.
