WACC We Will Assume That

WACC We will assume that the old machine is fully depreciated. This makes the tax burden on the disposal as $34,000. The depreciation expense on the new machine will reduce the tax burden, and the cost savings are assumed to translate directly to profit, which will increase the tax burden. The net effect is an increase in tax burden from the new machine of $37,400 per year, which subtracts from the cost savings, giving a net annual cash flow of $432,600. The net present value of the new machine therefore becomes $1,715,925.02.

The present cash flows are the outlay for the new machine, the proceeds from the disposal of the old machine and the tax on those proceeds. This totals $1,734,000. Therefore, the NPV of the purchase of the new machine is -$18,074.98. Theta Widgets should not purchase the new machine. Capital budgeting decisions are complex. There are many variables that must be taken into consideration. Moreover, the information being used to make the decision is almost entirely based on estimates.

The more accurate the inputs, the stronger the decision, but much of what goes into a capital budgeting decision is variable. Inflation, for example, can have a significant impact on the outcome of the decision. For the most part, cost of capital reflects past conditions. There may be some element of future decisions, but as soon as a variable such as inflation differs from the assumed rate of inflation, the figures changes. The cost of capital used to make the decision has an assumed rate of inflation built into it.

If the rate of inflation increases, that cost of capital becomes obsolete. For this reason, companies should set a conservative hurdle rate that assumes some adverse movement in the rate of inflation. Even in doing so, most companies will bear the risk of a sharp spike in inflation rates. The future cash flows would, in theory, need to be discounted at a higher rate to reflect the change in inflation. This will adversely affect the future value of those cash flows.

This in turn will reduce the present value of those flows, and can erode the positive net present value that was derived in order to make the investment decision in the first place. A firm will ideally be able to pass the inflation on to their customers in order to balance off the deterioration in value of the cash flows. Capital investment decisions are filled with uncertainty. There are several ways for a company to limit this uncertainty or build in safeguards against adverse consequences.

The first is to get the best information possible prior to making an investment decision. The figures used for future cash flows are going to be estimates, but some estimates are better than others. The higher the quality of the information in the first place, the more accurate your NPV calculations will be. Another way to deal with uncertainty is to make conservative estimates. A project that only has a positive NPV under ideal scenarios is not generally a worthwhile project.

The scenarios upon which the decision is made should be less-than-ideal case scenarios. Conservative estimates of future cash flows should be used, as should a high hurdle rate. This should be related to the market, not simply be plucked from the air, or generated strictly on the basis of internal considerations. By planning for a poor scenario, only the projects with the highest likelihood of success will be undertaken. Therefore, if adverse conditions occur, the project still has a good chance to deliver a positive net present value.

In addition, the additional costs associated with adverse conditions should be considered and built into the projections. Risk management, contingency planning and disaster recovery should all be included in the cash flow analysis, weighted to reflect the risk of those funds needing to be spent. The risks must be fully analyzed for the impact and the odds of that impact being incurred. The company should also safeguard against any negative conditions that it can reasonably expect.

For example, the odds of a negative circumstance occurring might be low, but the damage done if it does occur can be high. In a case like this, the best thing to do is to reduce the odds of negative circumstances occurring. Many negative externalities can not be controlled, but the damages stemming from them.