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COMM 112 Financial Information For Business

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COMM 112 Financial Information For Business

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Course Code: COMM112
University: Lincoln University College

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Country: Malaysia

Use the background information above and any other information you believe necessary to answer the following questions. Show ALL workings. Ignore income tax in your calculations.
1. Identify, using examples, TWO (2) specific risks associated with investment in the proposed new machine AND explain how these risks could impact the business.
2. Draw the cash flow time line for the investment and indicate the cash flow patterns represented on the cash flow time line.3. Calculate the annual depreciation expense for the proposed new machine. 4. Calculate the average accounting rate of return (ARR) of the proposed new machine.
5. Calculate the payback period (PP) of the proposed new machine.
6. Calculate the net present value (NPV) of the proposed new machine. 
7. Compute the internal rate of return (IRR) of the proposed new machine.
8. Given your answers to questions 4-7, explain whether or not Ronald should invest in the proposed new machine.9. Briefly discuss whether, and if so how, depreciation affects your calculations in question 4-7.
10. Identify, giving reasons, TWO (2) pieces of additional information that would aid Ronald in deciding whether or not to invest in the new machine. 

1) One risk could relate to increase in the cost capital for the project which would adversely impact the viability of the proposed machine. In order to mitigate this risk, sensitivity analysis ought to be considered to determine the underlying sensitivity of the key capital budgeting techniques such as NPV to the changes in the cost of capital. This will provide information to the management with regards to the extent of adverse cost of capital movement that the project can withstand (Damodaran, 2015).
2) Another risk could relate to uncertainty regarding the future estimates of inflows if there is any drastic change in the business environment which may not have been considered. In order to incorporate the same, scenario analysis is a useful tool. In this, cash flow estimates are worked out in the optimistic, base and pessimistic case along with highlighting the underlying probabilities of occurrence of these scenarios. Then, based on the respective probabilities of each scenario, a weighted NPV is worked out to see if this is positive or not (Petty et. al., 2015). 
3) Annual depreciation expense = (Initial Cost – Salvage Value)/Useful life
Based on the given information, initial cost of machinery = $ 106,250
Salvage value or residual value of the equipment at the end of the project = $15,000
Total useful life of the machinery =6 years
Hence, annual depreciation expense for the proposed machine = (106250-15000)/6 = $ 15,208.33 
4) The relevant formula for ARR is indicated below.
ARR = [(Total profit during the project useful life/Project Useful life)/Average investment ]*100 
Total profit during project useful life = $ 25,650
Project Useful life = 6 years
Average investment = $ 106,250
Hence, ARR = [(25650/6)/106250]*100 = 4.02% 
5) Payback period refers to the time required to recover the original investment (Parrino & Kidwell, 2014). In order to estimate the payback period in context of the given machine.
it is apparent that the cumulative project cash flows are negative in year 4 and become positive in year 5, hence payback period would lie between 4 and 5 years.
Payback period = 4+ (5600/15625) = 4.358 years
6) NPV(Net Present Value) refers to the sum of the present value of all the project net cash inflows and outflows arising during the project’s useful life (Brealey, Myers & Allen, 2014). The net cash flow for the proposed machine in every year is already available. Also, it is known that the cost of capital is 10%. Thus, the NPV can be computed as shown below.
NPV = -106,250 + (32500/1.1) + (28750/1.12) + (23150/1.13) + (16250/1.14) + (15625/1.15) + (15625/1.16) = -$ 5,930.51
From the above computation, it is apparent that proposed machinery NPV is -$ 5,930.51. 
7) IRR may be defined as the discount rate which tends to lead to NPV as being zero (Damodaran, 2015). Let the IRR for the proposed machinery be r%. Considering the IRR definition, the following relationship would be true.
0 = -106,250 + (32500/(1+r)) + (28750/(1+r)2) + (23150/(1+r)3) + (16250/(1+r)4) + (15625/(1+r)5) + (15625/(1+r)6)
Solving the above equation, we get r=7.74%
From the above computation, it is apparent that proposed machinery IRR is 7.74%. 
8) Ronald should not invest in the proposed machinery owing to the following reasons (Petty et. al., 2015).

The ARR of the project is lower than the minimum 14% hurdle rate that the company expects.
The payback period of the project is higher than the expected 4 years.
The NPV of the project is negative and hence the proposed machine would lower the firm value and destroy wealth for shareholders.
The IRR of the project is lower than the cost of capital (10%) which is not acceptable.

The above evidence hint towards the project not being financially feasible and therefore Ronald should not make investment in the proposed machinery. 
9) It is noteworthy that although depreciation is a non-cash charge, it has significant indirect influence on the net cash flows owing to the tax shield that it offers as it tends to lower the taxable profits. Thus, by lowering the net tax outflow, depreciation helps in enhancing the cash flow. With regards to the proposed machinery, the effect of depreciation would tend to enhance the overall cash flows on account of the tax shield (Parrino & Kidwell, 2014). However, in the given case since it is known that income tax effect ought to been ignored, hence depreciation does not impact any computations from 4-7. 
10) Two pieces of additional information which would be required to decide if investment in the proposed machinery would be made or not are indicated below (Petty et. al., 2015).

The estimated project cash flows tend to include the influence of tax or not as in capital budgeting post tax cash flows need to be considered. This is imperative since post tax cash inflows are typically lower than pre-tax cash inflows and tend to impact the project viability.
Another key information which is missing is whether the impact of depreciation in terms of tax shield has already been incorporated in the estimated cash inflow information that has been provided for the project.

The current analysis has been performed assuming that the cash flows provided are post tax and hence include the impact of depreciation tax shield.   
Brealey, R. A., Myers, S. C. & Allen, F. (2014) Principles of corporate finance, 6th ed. New York: McGraw-Hill Publications
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.
Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. & Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed..  NSW: Pearson Education, French Forest Australia

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