ASSESSMENT 2

ACG32: Finance and Investment - Assessment 2

ACG32: Finance and Investment - Assessment 2

Question B-1

-A-

Capital Budgeting Analysis

The capital budgeting analysis in this question should be undertaken on after-tax basis. Main objective of using after-tax cost of capital is that before tax income ignores the component of taxes that may result in changing the overall real return on the project. After-tax cash flows should be used in the capital budgeting analysis because investment in any project is based on the available after-tax cash.

-B-

Non-Incremental Cash Flows

In making a capital budgeting analysis, finance manager should consider only incremental cash flows. This includes installation costs, cost of equipment, cost of setting up operations, and change in working capital. In contrast, the given project contains non-incremental cash flows that do not show change once occurred. This includes the feasibility fee of $30,000 paid to Spinner Consulting and additional $1,000 of stock used in assessment process. This represents the non-incremental cash flow because if project is not accepted this cash flow will not be recovered and remain non-incremental in other years of capital budgeting evaluations.

-C-

Appropriate Required Rate of Return

Appropriate required rate of return to use in the current capital budgeting analysis is the after tax required rate of return as noted in book value that equals 13.157%. Book value after tax-cost required rate of return represent the total cost of capital that will be incurred by the Tipto as cost of capital. Therefore, project evaluation should be discounted on the same rate.

-D-

Required rate of return is often called 'cost of capital' for capital budgeting purposes because it represents the rate of return that investor is seeking from the business. Cost of capital represents the cost that is incurred in financing the business (Siegel, 2008, p. 147). Therefore, required rate of return should exceed the cost of capital in financing the business. Discounting the project cash outlay at the required rate of return provides information about the feasibility of the project and its acceptance. Thus, positive NPV shows that required rate of return exceeds the cost of capital.

-E (i)-

Annual Taxable Income

Annual taxable income for the last outlet opened is $ 95,000.

-E (ii)-

Annual after-tax net cash flows

EBT

95000

Less: Tax (30%)

28500

EAT

66500

Add: Depreciation

50000

After Tax Net Cash Flow

116500

Annual after-tax net cash flow would be $116500.

-E (iii)-

Project Net Present Value

After Tax Net Cash Flow

1165000

PVAIF r=13.157% t=10

5.39

DCF Year 1-10

$628,211

Initial Investment

$531,000

NPV

$97,211

Initial investment includes the investment in purchasing of equipment, feasibility studies fee, and stock cost used in the assessment process.

-E (iv)-

Rationale for Project Acceptance

Based on the calculated NPV, the project is acceptable. NPV based on ten years capital budgeting model appeared positive; therefore, project should be accepted. Positive NPV shows that internal rate of return of the project exceeds the market value after-tax required rate of return, i.e. 11.835%. Therefore, positive NPV provides rationale for the acceptance of project.

-F-

Responses to Magnus' Suspicion

Answer in the question does not eradicate the Magnus' suspicions about the limitations of the company's previous practices in analyzing investment ...