Capital budgeting analysis and decision-making frameworks

¶ … net cash flow for the second year would be if all cash expenses were as described in the scenario but there were no depreciation expenses. Explain the impact of depreciation on the net cash flow for the second year."

The correct cash flow for the second year would be as follows:

3170000-2400000 = 770000 *.7 = 5390000 would be the cash flow. The impact of depreciation on the net cash flow is that the depreciation has provided a tax shield that is equal to 32% of 300000= 96000. Based on the results, the cash flow would be lower than this amount.

"Based upon your NPV analysis in part A2, make a recommendation to Entrepreneur D

regarding what decision to make. Explain why this is an appropriate action."

Based on the NPV analysis, Entrepreneur D. should undertake the project as the present value because all cash inflows is greater than the present value of all cash outflows.

"Based upon your IRR analysis in part A3, make a recommendation to Entrepreneur D

regarding what decision to make. Explain why this is an appropriate action."

Entrepreneur D. should undertake the project because the Internal Rate of Return is higher than the cost of capital, which is 12%.

4. "Explain why the accounting rate of return on this project is different from the internal rate of return for the same capital investment."

The reason is that the Accounting Rate of Return is based on profit while Internal Rate of Return is based on present value of cash flows. Additionally IRR considers time value for money while ARR does not consider time value of money.

Capital Budgeting is the process of analyzing an organizational investment decision especially when a company decides to invest in new equipments, plants, machineries and project. The process of calculating capital budgeting involves calculating the Internal Rate of Returns (IRR), Accounting Rate of Return and Net Present Value (NPV). Internal Rate of Return is the discount rate that makes the Net Present Value to become zero. And if IRR is greater than the cost of capital, the investment is viable. However, Net Present Value (NPV) is the present value of cash inflows subtracted from the present value of all cash outflows, and if NPV is greater than zero or positive, the investment is viable.

On the other hand, Accounting Rate of Return (ARR) s is the average annual income derived from a project divided the initial investment.

There are several reasons why accounting rate of return on this project is different from the internal rate of return for the same capital investment.

First, accounting rate of return uses accounting profits in the capital budgeting while internal rate of return uses cash inflows. For example, the application of accounting profits is subject to different of accounting treatment which affecting bottom line of profits.

Typically, ARR could be calculated using book value project net income and it does not make use of cash flow. Unlike the ARR, the IRR make use of cash flows data for the value of the investment. Unlike IRR, which is making the business decision on cash flows, the ARR is not suitable for project evaluation decision because the ARR is making the returns on accounting profits.

The IRR is also known as yield method, and IRR of a project is the rate of discount at which the present value of cash flow is equal to the present value of cash inflow. While IRR base the value on rate of return, the ARR ignores the time value of money and it is not accounting based of return. Under ARR, depreciation is calculated in different methods such as accelerate or straight line, and the technique ignores the salvage value of the initial investment.

5. "Explain the relative significance of the unadjusted payback period in this decision situation."

Payback period assists in determining payback period in the life cycle of the project. Typically, it would be more than 8 years before NPV would become negative. However, the payback may not be useful in determining acceptance of a project because it ignores cash flow and does not consider time value for money after the payback in the life of a project.

Payback period is the time duration that is required to recoup the initial costs that has been committed in a project. The pay back period is the number of years that it will take cash flows from project to recover initial investment put in the project.

The relative significant of the unadjusted payback period in this situation is that payback period helps to determine the payback period in the project lifecycle. In the project, it would be more than 8 years before the Net Present Value (NPV) would be negative. Application of pay back is easy and it is easy to understand. Another significant of unadjusted pay back period is that it stress the period of recouping the investment put in the project.

The significant shortcoming of pay back period is that it ignores that cash inflows received after the payback period. Since payback period emphasizes on early recovery, it does not lay emphasis on the cash inflow after the payback period.