Capital Budgeting

Corporate Budget The correct net cash flow for the second year is $455,000 The impact of depreciation -- in all years -- is that it lowers the taxes payable. Depreciation is a non-cash expense, and therefore it lowers the taxable income of the organization. When the taxable income is lowered, the overall taxes are also lower. The depreciation does not count in the net cash flow, and therefore the net cash flow is going to be higher than the net income in any year where there is a depreciation charge.

It should be noted that you must use depreciation for this question. As per GAAP, you have to use depreciation on capital assets. This will create a tax benefit. The tax benefit is an incremental cash flow, and all incremental cash flows are to be included in a net present value calculation. Thus, to exclude the effect of depreciation would be to incorrectly calculate the incremental cash flows. It is recommended that the company undertake the project.

As a general rule, where there is only one alternative and the decision is a simple yes/no decision, projects with a positive net present value (NPV) should be undertaken. This is because such projects increase the value of the company. This project has a positive net present value of $124,980, and therefore it should be undertaken. 3. By IRR, it is recommended that the company undertakes the project. 3a. The IRR is this case is 13.145% and the discount rate is 12%.

If the IRR is higher than the discount rate, then the project should be undertaken. 4. The accounting rate of return is different from the internal rate of return, because the accounting rate of return includes non-cash items. Specifically in this case, the non-cash item is the depreciation expense. However, any non-cash item that is built into the accounting rate of return will render the accounting rate of return different from the internal rate of return.

This difference, the inclusion of the non-cash item of depreciation, is precisely why the accounting rate of return for the project is different from the internal rate of return on this project. The inclusion of depreciation means that the accounting return is different than the internal return, ergo the rates of return are also different. 5. The answer to the question "5. Explain the relative significance of the unadjusted payback period in this decision situation" is as follows: The unadjusted payback period can be significant in this decision.

The further out a payback period is, the more this increases the risk of the project. In this case, the project's payback period is 5 years and 4 months. There are a lot of things that can change in five years that affect the payback. In general, managers prefer shorter payback periods because there is lower risk associate with them. 6. The weighted average cost.