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CAPITAL INVESTMENT DECISIONS (or Capital Budgeting): Involves companys long term investment decision. It includes evaluation of firms expenditure decisions that involve current outlays but are likely to produce benefits or returns over a long period of time. Features/Characteristics of CID (Importance): # Long term investment decision (Future profitability of firm). # Returns or benefits are expected over number of years # Investment involves huge amount of cash outflow (Determines the destiny of the firm) # Investment decision is generally irreversible (Once made can not be changed) # Relatively high degree of risk # Relatively long time period between the initial outlay and the anticipated return After Tax Cash Flows Cash flows should always be after tax Conventional Cash Flow - It consists of an initial cash outlay followed by a series of cash inflows. Non-conventional Cash Flow - It consists initial cash outlay followed by alternative inflows and outflows and an inflow followed by outflows etc. Techniques of Capital Budgeting DCF Techniques: a) NPV (Net Present Value) = PV of Cash Inflow PV of Cash Outflow Accept-Reject Criterion: If NPV is positive, accept the project. If negative reject the project.
b) IRR (Internal Rate of Return) = Rate of discount that makes NPV of a project zero.
PV of CO = CI1/(1+IRR) + CI2/(1+IRR)2 + CI3/(1+IRR)3 + CI4/(1+IRR)4 + . Accept-Reject Criterion: If IRR > Discount Rate/Cost of Capital/Required Rate of Return (RRR), Accept the project, otherwise, reject the project.
The Sprint Inc. is trying to estimate the net cash outlay required to replace an old machine with a new one. The new machines purchase price is $270,000. An additional $5,000 will be required for transportation and another $5,000 will be required to install the machine. As the new machine has greater capacity to produce, there will be an additional investment of $20,000 in raw material inventory in the initial year. The new machine will be depreciated on straight-line basis over 10 years of useful life. The old machine was purchased two years ago at a cost of $70,000 has a remaining useful life of five years. It is also subject to straight-line depreciation. The company is entitled to investment tax allowance of 25%. The corporate tax rate is 55% and the capital gain tax rate is 30%. Find the net cash outlay considering separately each of the following scenarios: i) If the old machine is sold for $40,000 ii) If the old machine is sold for $50,000. iii) If the old machine is sold for $60,000. iv) If the old machine is sold for $90,000.