Capital budgeting analysis for machinery investment project

Capital Budgeting

The initial investment in machinery and equipment is $22,000 (all figures in $000s). If this is depreciated straight line over four years, the depreciation expense for each year will be $5,500. Depreciation is an expense, but it is not a cash flow. It does, however, affect cash flow, because it is recorded pre-tax, thereby reducing the tax burden. The tax rate is 34%. Therefore after-tax cash effect of depreciation is as follows:

This gives us the following table:

Depreciation Table

Depreciation Exp

After Tax Benefit

Tax rate

The first step in creating an after-tax cash flow statement is to analyze the relevant streams. The initial investment is recorded as a cash flow, but is not immediately subject to taxation. The taxation comes in years 1-4, as depreciation. Because the project will be fully depreciated, the salvage value is fully taxable as a form of income. So the first step gives us the following pre-depreciation chart:

Net Flow

From there, we can use our weighted-average cost of capital to compute net present value (NPV). The WACC was 3.9688%. Therefore the NPV is going to be as follows:

Post Tax

Depreciation

Net Flow

PV

WACC

NPV

3) to: Management

Re: New Project

The net present value of the project is $6,954.47. Therefore, we should accept the project. The cash flows are discounted by our weighted-average cost of capital. This rate is used as the discount rate because it represents what new money costs JNJ. New capital must come either as debt or as equity. We calculated the cost of equity and the cost of debt. Then, we weighed these figures against our current capital structure in order to determine the weighted average cost of capital. If a project only returned what it costs the company to acquire the capital in the first place, the net present value would be zero. Therefore, if the project has a positive NPV, this means that the project returns to JNJ more than what it will cost us to acquire the capital to undertake the project in the first place. Since the NPV is $6,954.47, we should undertake the project.

4) the above calculation is based on real terms cash flow. This is based on the assumption that it is reasonable to project today's conditions into the future. if, however, our economists assume that inflation is going to increase in the coming years, we should make adjustments to our calculations to account for this. An increase in inflation will reduce the value of future cash flows. The negative affect of time on the value of future cash flows is already reflected in the discount rate. So inflation fits into the calculation in terms of the discount rate, because it is reflective of market risk.