Dimple Patel

07/05/17
ACT 5733
Advanced Managerial Accounting

HW #4: Capital Budgeting and Cost Analysis

Question #1
Consider the following potential investment, which has the same risk as the firms other projects:

Time CF
0 ($600,000)
1 $145,000
2 $150,000
3 $150,000
4 $175,000
5 $180,000
6 $190,000

a) What are the investments payback period, IRR, and NPV, assuming the firms WACC is
10%?
Capital budgeting involves making decisions about investments in projects on a long-
term basis. These types of expenditures can impact a company for years. Unfortunately,
these projects long-term nature make them difficult to evaluate, and some of the projects
may be hard to reverse should the projects attributes change. The most important factors
in making proper capital budgeting decisions include analyzing lifespan cash flows of a
project start to finish (really, initial investment to termination). For example, if SAP
(Systems, Applications, and Products in Data Processing company) were to develop a
mobile enterprise app, the company would have to gauge the potential costs and benefits
(revenues) of the project all the way from its initial research and development stage to its
final stage in customer service.

Capital budgeting decisions hinge on a five-step process. The first step involves
identifying potential investments that agree with the companys overall strategy. In the SAP
example, the company has to decide whether the mobile app is a fit in the companys
overall stratregy of tapping into the business potential of technology. The second step
involves gathering information from all parts of a value chain to assess alternative projects.
For instance, perhaps SAP finds out that the mobile app would not support small business
functions in a mobile environment, so they may reject this project in favor of a more
feasible one. The third step of the capital budgeting decision making process is forecasting
all potential ash flows attributable to the alternative projects. Theres a high level of
uncertainty in regards to estimated future cash flows involving potential projects, so
companies analyze a plethora of projects before picking an ideal one. By weighing the
annual cash inflows and disposal value, a value from the projects end, against the initial
expenditures of the capital investment projects, companies are ensuring that they

1
confidently choose financially sound ventures. The fourth step involves determining which
investment has the great benefit and the least cost to the organization. Assuming that the
predicted values made in step 3 were done with a high confident interval, the company has
to employ a certain capital budgeting method to pick the best project out of the lot.
Financial information is imperative, but qualitative information as assessed by managers
can play a substantive role in decision-making. Step five involves obtaining funding and
making the investments chosen in step four. Then, as a sort of feedback tool, the capital
budget decision making process necessitates measurement of realized cash flows that need
to be compared to the predicted values. If the actual cash inflows and outflows are
disparate from the estimated values, then the company needs to switch gears and revise
their investment plan. For instance, if SAPs mobile app is not generating enough sales,
maybe SAP needs to invest a stronger marketing campaign to break into new consumer
markets to yield revenue growth.

Step four involves financial analysis, which more specifically entails the calculation of
such metrics like the net present value (NPV), internal rate of return (IRR), and payback
period. The former two methods, NPV and IRR, implement discounted cash flows.
Discounted cash flow metrics discount expected future cash inflows and outflows of a
project back to the present; this method implements the time value of money in that a
present-day dollar is worth more than a dollar obtained in the future.

The net present value method uses the discounted cash flow method with the required
rate of return to obtain the expected financial gains or losses from an investment project.
Essentially, the NPV method gauges how much value is created or destroyed by the
investment project by comparing present values of cash inflows to those of cash outflows. If
the NPV value exceeds zero, then the project is typically favorable. The method also uses
the weighted-average cost of capital (WACC), which equals the after-tax average cost of all
long-term funds used by the company. This three-pronged method involves first drawing a
sketch of the relevant cash inflows and outflows of the project to help in data visualization
and organization; all cash flows must be accounted for, including those from operations,
equipment sale or purchase, or working capital recovery/investment. Accrual-accounting
methods are not implemented as the net present values primary concerns are the cash
inflows and outflows. The first step is already provided for the firm in this problem. The
second step involves discounting the cash flows using the correct compound interest table
and then adding the values. Discounting cash flows involves multiplying the present value
of $1 at a specified WACC rate by the relevant cash flow at the end of a given period. In this
case, the interest table uses the 10% WACC column for 6 periods as illustrated below:

= ( $1 )
( )

= ( $1 10%)
( )

2
 = (. 909) ($145,000) = $131,805

Present-Day
Time Period Cash Flow Value of $1 at Present-Value of
10% Cash Flow
0 ($600,000) 1 ($600,000)
1 $145,000 0.909 $131,805
2 $150,000 0.826 $123,900
3 $150,000 0.751 $112,650
4 $175,000 0.683 $119,525
5 $180,000 0.621 $111,780
6 $190,000 0.564 $107,160
Total $106,820

Note that according to the previous calculations, the present value of just benefits is
$600,000 more than the net present value, an objective decision metric, for the initial
$600,000 cost in the first period is negative. Because the net present value of $106,820 is
greater than 0, the project should be accepted.

The next metric, the internal rate of return (IRR), calculates the rate of return implicit in
a series of cash flows. Essentially, the internal rate-of-return metric measures the discount
rate at which an investments present value of all expected cash inflows equals the present
value of its expected cash outflows. The IRR uses the discount rate in which the net present
value equals 0. The Time Value of Money concept is taken into account when calculating the
IRR, and the IRR includes all cash flows of the investment project. Like the NPV rule, the
IRR is an objective decision metric and generally mirrors the decisions obtained with the
net present value. Multiple IRRs can be calculated.

This capital budgeting method is usually approached in a trial-and-error manner. The

first step involves using a discount rate and calculating the projects net present value. The
second step depends on the calculated net present value from the first step; if the net
present value is less than zero, a lower discount rate should be used as a lower discount
rate increases the net present value calculation, but if the net present value is greater than
zero, a higher discount rate needs to be implemented to yield a lower net present value.
This aforementioned step needs to be repeated until for the discount rate until NPV equals
$0. In this problem, because the net present value was greater than zero, a higher discount
rate should be used to lower the NPV. The following calculations were incurred to arrive at
the IRR:

= ( $1 10%)
( )

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 Present- Present- Present- Present- Present- Present-
Day Value Value of Day Value Value of Day Value Value of
Cash Flow
of $1 at Cash Flow at of $1 at Cash Flow at of $1 at Cash Flow at
12% 12% 14% 14% 16% 16%
($600,000) 1 ($600,000) 1 ($600,000) 1 ($600,000)
$145,000 0.893 $129,485 0.877 $127,165 0.862 $124,990
$150,000 0.797 $119,550 0.769 $115,350 0.743 $111,450
$150,000 0.712 $106,800 0.675 $101,250 0.641 $96,150
$175,000 0.636 $111,300 0.592 $103,600 0.552 $96,600
$180,000 0.567 $102,060 0.519 $93,420 0.476 $85,680
$190,000 0.507 $96,330 0.456 $86,640 0.41 $77,900
Total $65,525 $27,425 ($7,230)

Per the above calculated table, the WAPP rate should be focused on somewhere
between 14% and 16%. A weighted proportion method can be used to find the ideal IRR
that would yield a net present value of 0 by adding the total present value (TPV) at both
rates (note that a ratio is needed, so the total present value at 16% is used at its absolute
value)

( 14%)
= 2% + 14%
( 14%) + | 16%|

$27,425
= 2% + 14% = 15.58%
($27,425) + |$7,230|

Therefore, the internal rate of return for this project that yields a net present value
of 0 is 15.58%.

The final metric, the payback method, is easy to calculate and does not utilize the
time value of money. It also ignores cash flows after the payback occurs and does not
distinguish among the sources of cash flows. Payback, unlike the net present value and the
internal rate of return method, is more of a subjective decision rule, which means that the
method is better as a component, but not as the decisive linchpin, in deciding whether to
accept an investment project. The payback method gauges the time it will take to recover a
projects net initial investment in expected future cash flows. The payback method is easier
to calculate for uniform cash flows; however, the nonuniform cash flows require a fairly
simple computation in that the cash flows over successive periods are added together net
initial investment is recouped. The following general formula provides the amount of the
aggregate cash flow:

= ( 0 )
+ ( 1 )

= ($600,000) + ($145,000) = $455,000

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 Time Period Cash Flow Aggregate Cash Flow
0 ($600,000) ($600,000)
1 $145,000 ($455,000)
2 $150,000 ($305,000)
3 $150,000 ($155,000)
4 $175,000 $20,000
5 $180,000 $200,000
6 $190,000 $390,000

Therefore, the payback period is sometime between the 3rd year and the 4th year as
the aggregate cash flow goes from a negative $155,000 to a positive value of $20,000.
Again, a weighted-proportion formula helps in determining the exact payback period of
3.89 years:

| 3 |
=
( 4 ) + | 3 |
1 + 3

|$155,000|
= 1 + 3 = 3.89
($20,000) + |$155,000|

The NPV is $106,820; the IRR is 15.58%; and the payback period is 3.89 years.

b) If the firm requires a payback period of less than 4 years, should this project be accepted?
Be sure to justify your choice.

The payback method for nonuniform cash flows requires a simple computation in
that the cash flows over successive periods are added together net initial investment is
recouped. The following general formula provides the amount of the aggregate cash flow:

= ( 0 )
+ ( 1 )

= ($600,000) + ($145,000) = $455,000

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 Time Period Cash Flow Aggregate Cash Flow
0 ($600,000) ($600,000)
1 $145,000 ($455,000)
2 $150,000 ($305,000)
3 $150,000 ($155,000)
4 $175,000 $20,000
5 $180,000 $200,000
6 $190,000 $390,000

| 3 |
=
( 4 ) + | 3 |
1 + 3

|$155,000|
= 1 + 3 = 3.89
($20,000) + |$155,000|

Because the exact payback method is calculated to be 3.89 years, the companys
stipulation that the project adhere to a less than 4-year deadline is feasible given that the
initial investment will be recouped under 4 years.

However, a better picture could be visualized by calculating the discounted payback

method using the WACC to calculate the present value of cash flows. The discounted
payback method takes time value of money into account and ignores cash-flows after
payback. Again, like the regular payback method, this payback method is a subjective
decision rule and shouldnt be the end-all-be-all in rejecting or accepting an investment
project. Also, in the calculates, net present value is utilized. The following work provides
the present value of cash flows to determine the net present value:

= ( $1 )
( )

= ( $1 10%)
( )

= (. 909) ($145,000) = $131,805

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 Present-Day
Time Period Cash Flow Value of $1 at Present-Value of
10% Cash Flow
0 ($600,000) 1 ($600,000)
1 $145,000 0.909 $131,805
2 $150,000 0.826 $123,900
3 $150,000 0.751 $112,650
4 $175,000 0.683 $119,525
5 $180,000 0.621 $111,780
6 $190,000 0.564 $107,160
Total $106,820

Then the discounted payback period is determined by the following calculations:

= ( 0 )
+ ( 1 )

= ($600,000) + ($131,805) = $468,195

Aggregate Cash
Time Period Cash Flow
Flow
0 ($600,000) ($600,000)
1 $131,805 ($468,195)
2 $123,900 ($344,295)
3 $112,650 ($231,645)
4 $119,525 ($112,120)
5 $111,780 ($340)
6 $107,160 $106,820

Therefore, the payback period is sometime between the 5th year and the 6th year as
the aggregate cash flow goes from a negative $340 to a positive value of $106,820. Again, a
weighted-proportion formula helps in determining the exact discount payback period:

| 3 |
=
( 4 ) + | 3 |
1 + 5

|$340|
= 1 + 5 = 5.003
($106,820) + |$340|

Because the exact discount payback method is calculated to be 5.003 years, the
companys stipulation that the project adhere to a less than 4-year deadline is not feasible
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given that the initial investment will be recouped only after a little over 5 years. Therefore,
the company would incur severe financial losses if it imposed a less than 4-year deadline.

In terms of the regular payback period, the project should be accepted. In terms
of the discounted payback period, the project should be rejected.

c) Based on the IRR and NPV rules, should this project be accepted? Be sure to justify
your choice.

Note that according to the calculations for this firm, the present value of just
benefits is $600,000 more than the net present value, an objective decision metric, for
the initial $600,000 cost in the first period is negative. Because the net present value of
$106,820 is greater than 0, the project should be accepted as the positive net present
value indicates that value was created with this investment, or that the present-day
value of cash inflows exceeded those of cash outflows.

Whether or not the project should be accepted using the internal rate of return of
15.58% depends on the hurdle rate. If the internal return rate exceeds the hurdle rate,
then the rate should be accepted, and the project will have a positive net present value;
however, if the internal return rate is less than the hurdle rate, then the rate should be
rejected as the project will have a negative net present value. In this case, it will be
assumed that the IRR follows the directionality of the decision made using the current
firms NPV. Because the net present value in this case was favorable, then the IRR
should be valid in accepting this project.

Based on both the IRR and the NPV, yes, the project should be accepted.

d) Which of the decision rules (payback, NPV, or IRR) do you think is the best rule for a
firm to use when evaluating projects? Be sure to justify your choice.

All three methodologies----NPV, IRR, and the payback----for major capital budgeting
decisions have their share of both advantages and advantages. Therefore, in order to
determine the best rule for a firm to use when evaluating projects, all three methods must
be compared. First, the payback method is extremely easy to calculate. The payback
methodology provides another metric against which projects can be rejected or accepted.
Moreover, when interest rates are substantively high, the payback method can provide
managers a good timeline for when expensive investment expenditures can be recouped.
Moreover, although companies try to gather accurate data, sometimes the predicted future
cash flows can have a grain of unreliability, especially in time periods in the later stages of
the projects implementation. Therefore, the payback method would ensure that companies
are realistically timing the duration of their investment project without hoping for
substantive later cash flow gains. Unfortunately, the payback method ignores both cash
flows after the payback period and ignores the time value of money. Also, the payback
method is an extremely subjective metric as managers themselves choose the cutoff period

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for project acceptance; moreover, payback methods may reject long-term projects with
other positive metrics if the selected cut-off periods are short---shorter periods that ensure
more liquid investment projects.

Companies find the internal rate of return method useful as it corroborates the
conclusions drawn from the net present value method. If a company needs more
reassurance that investment in a project is a good decision, they can calculate the IRR in
addition to the NPV to substantiate their decision. Moreover, the IRR method is simple to
calculate and use in decision-making. Also, the IRR is an objective metric, which is more
reliable than the subjective measurement, the payback method. Unfortunately, the internal
rate of return method may have some errors when comparing separate projects with
disparate time lengths or unequal investment amounts as the method assumed that the
projects cash flows can be applied at the projects rate of return.

Probably the most reliable metric, the NPV takes into account both the time value of
money and the estimated cash flows. It also assumes that the projected cash flows will use
the required rate of return in their reinvestment. Also, sometimes managers find that the
dollar unit of the NPV---versus the percentage unit of measure for IRR and the time unit of
measure for the payback method---may be easier to comprehend in making capital
budgeting decisions. Also, if the company is weighing the benefits of numerous projects in a
big portfolio, the NPV can be totaled for the entire portfolio, which is not possible with the
IRR. Also, the net present value method does not have to rely on the fluctuations of the
required rates of return that the company may undergo, so it may be more reliable than the
potentially fickle IRR. Also, out of all the metrics, the NPV is the one methodology that the
companys shareholders and investors can gauge the future boons of their investment into
the project as the NPV predicts future gains (net losses) in todays dollars for the project.

The NPV has numerous advantages for determining project success, so the NPV
method should be used.

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Question #2
Your company is interested in having a new facility constructed. The contractor expects that it
will take approximately 3 years to complete the building. The contractor has offered you three
payment plans for the building. They are as follows:

Time Plan 1 Plan 2 Plan 3

Today $14,400,000 $21,600,000 $0
1 year from now $46,800,000 $0 $78,300,000
2 years from now $46,800,000 $68,400,000 $0
3 years from now $46,800,000 $68,400,000 $78,300,000

The CFO of your company has asked you to provide recommendation concerning which
payment plan to accept. What is your recommendation? Assume your weighted-average cost of
capital is 10%.

Given that as previously determined, the NPV value is the most reliable metric for
gauging recommendations of an investment projects payment plan, the NPV value at the WACC
rate of 10% will be calculated for all three plans.

In this case, the interest table uses the 10% WACC column for 3 periods as illustrated
below:

= ( $1 )
( )

= ( $1 10%)
( )

= (. 909) ($14,400,000) = $13,089,600

Present-Day Value
Time Plan 1 of $1 at 10% Present-Value of Cash Flow
Today ($14,400,000) 1 ($14,400,000)
1 year from now ($46,800,000) 0.909 ($42,541,200)
2 years from now ($46,800,000) 0.826 ($38,656,800)
3 years from now ($46,800,000) 0.751 ($35,146,800)
Total ($130,744,800)

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 Present-Day Value Present-Value of Cash
Time Plan 2 of $1 at 10% Flow
Today ($21,600,000) 1 ($21,600,000)
1 year from now $0 0.909 $0
2 years from now ($68,400,000) 0.826 ($56,498,400)
3 years from now ($68,400,000) 0.751 ($51,368,400)
Total ($129,466,800)

Present-Day Value
Time Plan 3 of $1 at 10% Present-Value of Cash Flow
Today $0 1 $0
1 year from now ($78,300,000) 0.909 ($71,174,700)
2 years from now $0 0.826 $0
3 years from now ($78,300,000) 0.751 ($58,803,300)
Total ($129,978,000)

The net present value method was used because there is no pertinent information
regarding the projects potential cash inflows. If the potential cash inflows of the
investment project were available, then the IRR method could be feasible. Perhaps
hypothetical cash inflows could be used for the projects future time periods; however, this
action is extremely subjective and would not accurately compare the three plans for
contract payment. The same reasoning is applied in avoiding both the regular and the
discounted payback methods. Also, all the values for the proposed cash outflows are
negative as these are companys payments to its contractor.

Considering that the net present value of cash flows for the project in all three
payment plans are in the negative, the CFO should pick a plan that has the smallest negative
quantity, rather the smallest absolute value of the NPV. The NPV with the smallest absolute
value yields the smallest cash outflow in todays dollars for the company, which means the
company would lose less money in funding this facility and paying the contractor. Based
solely on the calculated NPV, plan 1 would cost $130.8 million; plan 2, $129.5 million; and
plan 3, $130.0 million. With these calculations, the CFO should pick plan 2 as this plan
yields the least amount of costs in present-day values. In contrast, the CFO could just look
at raw cost quantities in picking a plan. Adding the raw numbers for payments for each
plan, plan 1 costs $154.8 million; plan 2, $158.4 million; and plan 3, $156.6 million. Based
on this raw quantity comparison, plan 1 would be the most favorable for the company if it
wants to minimize cash outflows to the facilitys contractor. However, such a comparison
would be inaccurate because NPV is a reliable measure as it takes into account discounted
cash flows.

The CFO should pick plan 2.

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Question #3
A firm believes it can generate an additional $2,750,000 per year in revenues for the next 10
years if it replaces existing equipment that is no longer usable with new equipment that costs
$4,600,000. The existing equipment has a book value of $70,000 and a market value of $30,000.
The firm expects to be able to sell the new equipment when it is finished using it (after 10 years)
for $200,000. Variable costs are expected to be 45% of revenue for the entire 10 years. The
additional sales will require an initial investment in net working capital of $275,000, which is
expected to be recovered at the end of the project (after 10 years). Assume the firm uses straight
line depreciation, its marginal tax rate is 38%, and the discount rate for the project is 14%.

a) How much value will this new equipment create for the firm?

An investment project like this new equipment necessitates three cash flow
categories in the capital budgeting decision making process: net initial investment in the
project, after-tax operations cash flow, and after-tax cash flow from terminal disposal of an
asset and recovery of working capital. The first category includes asset acquisition and
other working capital investments after deducting the after-tax cash flow from disposal of
current equipment. The second category also includes income tax cash savings due to
depreciation deductions made every year.

In terms of operating cash flows, this category includes the differences in cash flows
between each operational year under two project/equipment implementation alternatives.
Also, the operating cash flow involves incremental cash revenues and expenses; any
incremental depreciation expenses provide a beneficial tax shield as theyll yield income
tax cash savings. To figure out the amount of value that the purchase of the new equipment
will bring to the company, amounts like the depreciation expense, variable costs, taxable
income, tax amount, and operating income must be calculated in order to yield the
incremental operating cash flow. The following calculations use imputed values in
succession to figure out the value created by the new equipment:

( )
=
( )

($4,600,000)
= = $460,000
(10 )

= ( ) ( )

= (45%) ($2,750,000) = $1,237,500

= ( ) [( ) +
( )]

= ($2,750,000) [($1,237,500)] + ($460,000)] = $1,052,500

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 = ( ) ( )

= (38%) ($1,052,500) = $399,950

= ( ) ( )

= ($1,052,500) ($399,950) = $652,550

= ( ) + ( )
= ($652,550) + ($460,000) = $1,112,550

Metric Amount
Incremental Revenue $2,750,000
Incremental Variable Costs ($1,237,500)
Depreciation expense ($460,000)
Taxable income $1,052,500
Taxes (38%) ($399,950)
Incremental operating cash flow $1,112,550

Operating income $652,550

Add depreciation expense ($460,000)
Incremental operating cash flow $1,112,550

Therefore, this new equipment will create $1,112,500 annually for the company for
10 years.

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b) At what discount rate will this project break even?

To figure out the discount rate at which this project will break even, the other cash
flow categories need to be calculated. The first category, the net initial investment includes
any cash outflows to purchase the equipment, cash outflows for working capital, and after-
tax cash inflow or outflow from disposing the old equipment; therefore, typically two out of
three components of the net initial investment are cash outflows and start at the projects
inception. Cash outflows for equipment also include any costs incurred from relocating the
equipment at the companys site and rendering it in working condition. Moreover, in
disposing the equipment, the cash inflow or outflow must be added as this amount shows
the difference between buying or not buying the new equipment. Typically, the old
equipments book value is used to calculate the loss or gain on the equipment which would
in turn deduct the amount of taxable income to yield a cash inflow from tax savings.

In this case, the book value is less than the market value of the old equipment, so the
company would incur a taxable loss upon disposing of the equipment. Moreover, because
this taxable loss decreases the companys income, the company can save on taxes during
the year of the disposal and arrive at a net salvage value from equipment disposal. The
following calculations were done to calculate taxable loss, tax benefits, and net salvage
value; note that the taxable difference was imputed into the taxes incurred formula, which
in turn helped yield the net salvage value:

= ( ) ( )
= ($70,000) ($30,000) = $40,000

= ( ) ( )

= (38%) ($40,000) = $15,200

= ( ) + ( )

= ($15,200) + ($30,000) = $45,200

Old Equipment Disposal Metric Amount

Book value $70,000
Market Value $30,000
Taxable loss $40,000
Taxes saved from loss (38%) $15,200
Net Salvage $45,200

A firm believes it can generate an additional $2,750,000 per year in revenues for the
next 10 years if it replaces existing equipment that is no longer usable with new equipment
that costs $4,600,000. The existing equipment has a book value of $70,000 and a market
14
value of $30,000. The firm expects to be able to sell the new equipment when it is finished
using it (after 10 years) for $200,000. Variable costs are expected to be 45% of revenue for
the entire 10 years. The additional sales will require an initial investment in net working
capital of $275,000, which is expected to be recovered at the end of the project (after 10
years). Assume the firm uses straight line depreciation, its marginal tax rate is 38%, and
the discount rate for the project is 14%.

Upon calculating the old equipments salvage value, the net outflow at the new
equipments inception can be found by adding the working capital amount, the new
equipment purchase price, and the net salvage value together:

0
= ( ) + ( )
+ ( )

0 = ($4,600,000) + ($275,000) + ($45,200) = $4,829,800

Metric Amount
New Equipment ($4,600,000)
Working Capital ($275,000)
Net Salvage Value $45,200
Net Outflow at t=0 -

The final piece of the cash flow puzzle involves figuring out the end-of-the-project cash
flows upon selling the new equipment and terminating the project altogether. The following
calculations are made to figure-out the after-tax salvage value of the new equipment, taxable
gain upon selling said equipment, the taxes on said gain, etc. in order to yield the total end of
project cash flow (under the assumption that the straight-line depreciation method will yield a
book value of $0 for the new equipment):

( )
= ( )
( )

( ) = ($200,000 ) ($0) = $200,000

= ( ) ( )

= (38%) ($200,000) = $76,000

= ( ) ( )

= ($200,000) ($76,000) = $124,000

15

= ( ) + ( )

= ($124,000) + ($275,000) = $399,000

Metric Amount
After-Tax Salvage Value $124,000
Recovery of Working Capital $275,000
Total End of Project Cash Flow $399,000

Expected Sales Value $200,000

Book Value $0
Taxable Gain $200,000
Taxes on Gain ($76,000)
After-Tax Salvage Value $124,000

Using the aforementioned NPV formulas as well as the IRR formulas, the following
table provides a calculation for the discount rate at which the project will break even in 10
years by including the initial investment cash output for time at 0 years, incremental
revenue for all the other periods, and the sum of the incremental revenue and total end of
project cash flow for the 10th year:

Present Present
Value of $1 Present Value of $1
at Value for Aggregate at Present Value
Time Cash Flow WACC=14% Cash Flow Cash WACC=16% for Cash Flow
0 -$4,829,800 1 -$4,829,800 -$4,829,800 1 -$4,829,800
1 $1,112,500 0.877 $975,663 -$3,854,138 0.862 -$3,322,267
2 $1,112,500 0.769 $855,513 -$2,998,625 0.743 -$2,227,978
3 $1,112,500 0.675 $750,938 -$2,247,688 0.641 -$1,440,768
4 $1,112,500 0.592 $658,600 -$1,589,088 0.552 -$877,176
5 $1,112,500 0.519 $577,388 -$1,011,700 0.476 -$481,569
6 $1,112,500 0.456 $507,300 -$504,400 0.41 -$206,804
7 $1,112,500 0.4 $445,000 -$59,400 0.354 -$21,028
8 $1,112,500 0.351 $390,488 $331,088 0.305 $100,982
9 $1,112,500 0.308 $342,650 $673,738 0.236 $159,002
10 $1,511,500 0.27 $408,105 $1,081,843 0.227 $245,578
$6,694,200 $1,081,843 -$12,901,828
Then, seeing how the NPV value changes from a positive value to a negative value
when changing the discount rate from 14% to 16%, the weighted ratio formula was used to
calculate the final discount value (see aforementioned equations in problem 1) of 14.15%,
which is the amount the project will break even after 10 years.

Break-even discount rate is 14.15%.

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----

c) Should the firm purchase the new equipment? Be sure to justify your recommendation.

Yes, the company should purchase the new equipment because the incremental
revenue or cash input per year was positive. Moreover, at the current discount rate of 14%,
the positive net present value, an extremely reliable metric, would also be positive,
meaning that the firm is creating value by adding this equipment even after accounting for
all necessary cash outputs like the initial investment and annual variable costs amount.
Furthermore, the discount rate at which point the project will break even is at 14.15%,
which is reasonable when comparing it to the firms actual discount rate of 14%. This
means that the project would not yield a lesser present cash value to recuperate the initial
investment costs if cash outflows were not accounted for past the break-even point.

Yes, the company should purchase the new equipment.

d) How would your analysis change if the firm believes the project is more risky than initially
expected? Be specific.

If the project was riskier, then the company would not be confident in the amount of
projected revenues for the purchase of the new equipment, thereby lending to poorer
projected incremental revenues evaluated at a lower confidence interval. Moreover, other
notions like the recovery of the initial investment and the high selling price of the original
equipment may not be as certain as previously indicated and would also yield a lower end-
of-project cash output. Moreover, in order to get the new equipment up and running and
operational and revenue-generating, the company may have to invest a higher initial
investment amount than previously indicated, which would also factor into a lowered NPV.
The combination of higher cash outputs and lower cash inputs would mean that the project
would not be feasible unless changes were made to lower the risk of the investment
venture.

NPV values would decrease if the project was riskier as the projected revenues or
cash inputs would decrease and other cash outputs would increase.

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References

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2014). Cost accounting: a managerial
emphasis. Pearson .

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