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Earnings And Cash Flow Essay Sample

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Earnings And Cash Flow Essay Sample

The nature and characteristics of capital investment decisions warrant a careful analysis of investment alternatives.  A set of systematic capital budgeting procedures is necessary to ensure that all capital investment proposals are evaluated considering the organization’s goals and policies so that the best alternative is undertaken.  The importance of a systematic process is highlighted by the difficulty of evaluating capital investment proposal since it involves the future.  As such, many methods or techniques are developed and used to provide decision makers an educated and rational choice in the midst of the future’s uncertainty.

The capital budgeting process may vary among firms, but they usually go through the basic stages of the process.  In the first phase, different departments submit their capital project proposals along with the preparation of the master budget plan.  In doing so, the costs and benefits are estimated, considering the corporate criteria set.  This is quite strenuous since projects involve estimation that encompasses a number of years.  As a rule of thumb, the longer the time for the realization and recovery of the investment, the more risky the project is.  Once the project proposals are gathered, they are evaluated in the light of the firm’s goals and policies.  This is the stage where both quantitative and qualitative factors are put into play.  Upon approval, the capital budget is prepared that may look as a simple as a list of all approved projects or as complex as the inclusion of detailed descriptive data about each.  Finally, projects are reevaluated periodically to determine if the projects are still in line with the original expectations.  The firm can learn two important things in this stage.  First, errors committed would serve as a learning point in making realistic predictions; and secondly, it gives the firm the chance to compare existing projects with alternative capital investment opportunities.

The overarching justification for pushing through with a capital investment is its effect on the firm as a whole.  Since the firm would lay a considerable amount of money on a project, it should recover the investment through the project’s net cash inflow.  The type of project dictates the type of annual cash inflow.  For replacement of existing but old machinery for instance, cash inflow could be the savings on avoidable repair costs of the old machinery.  For a project characterized by a significant improvement in business processes, cash inflow normally includes the additional income the new project would contribute.  The same can be said for an expansion project such as an introduction of a new product line, in addition to the strategic affect on the business as a whole.  Whether the effect is savings or additional income, the yield of a successful capital investment would ultimately affect the firm’s periodic business performance.  If the net income is high, and on the presumption that total shareholder’s equity changed minimally, return on equity increases.

In making capital investment decisions, quantitative evaluation methods are usually employed.  This can be grouped into two basic classifications: those that consider the time value of money or the discounted cash flow methods and those that shun altogether the time value of money.  For the first classification, the most common method used is the net present value method.  All cash inflows or outflows related to the investment project are discounted at a minimum acceptable rate or return which, in most cases, is the firm’s cost of capital.  The project is acceptable if the present value of cash inflows is greater than the present value of cash outflows.  The difference between the two present values is called the Net Present Value (NPV).

In this light then, the investment proposal is acceptable since it would provide the firm with a positive NPV amounting to $551,790.  This is arrived at after considering the total cash inflow, comprised of the incremental revenue, depreciation and the tax savings on depreciation and additional expenses that would otherwise reduce income.  On the other hand, the initial cash outflow is composed of the incremental cost, the incremental tax on income resulting from this investment, and the additional expenses in leasing and online cost.  It should be noted that the initial cash outflow need not be converted to present value since it is inherently at its present value as if the investment is made today.

The payback period method is a simple method that computes the length of time to recover the cost of initial investment.  The annual cash inflow is applied against the initial investment in order to determine the balance of investment that needs recovering.  Based on the computation, Superior Living would be able to recover the investment in approximately 4 years and 3 months.  A modification of the regular payback period method, the present value payback period, applies the present value of cash inflow against the cost of investment, instead of the estimated cash inflow per se.

The result of the computation reveals that the project has an MIRR of about ± 15%.  This is better than first and second hurdle rates of 10% and 15%.  Though 20% likewise serves as a hurdle, it is least to say an unrealistic rate.  As such, since two hurdle rates were exceeded, the project is attractive even in the perspective of corporate finance.

This project is consistent with the company’s strategic thrust, particularly in the development and implementation of new product lines since the new plant would be able to accommodate additional production.  From this expanded production capacity, Superior Living would be able to generate estimated additional revenue of $3,500,000 annually.  Considering the average cost of goods sold of 49%, incremental income will then be at $1,785,000 annually.  In the investor’s perspective, this is favorable since the company is heading towards better business profitability.

Under general criteria, since the proposal yielded a positive NPV, a payback period shorter than the total life of the investment itself, and an internal rate of return greater than the realistic hurdle rates, the project is both attractive and favorable to Superior Living.

SOURCE:

Peterson, Pamela & Fabozzi, Frank. “Capital Budgeting and Evaluation Techniques.” Capital Budgeting. New York, New York: John Wiley & Sons, 2004. 57-117

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