Financial Analysis of Proposed Machine Investment Project

This assignment provides a comprehensive financial analysis of a proposed machine investment. It begins by identifying and mitigating potential risks such as increased cost of capital and uncertain future cash flows using sensitivity and scenario analysis. The analysis includes a detailed cash flow timeline and calculates the annual depreciation expense. The core of the assignment involves calculating key capital budgeting metrics including the Accounting Rate of Return (ARR), payback period, Net Present Value (NPV), and Internal Rate of Return (IRR). Based on these calculations, the assignment concludes with a recommendation on whether or not to invest in the proposed machinery, justifying the decision based on the financial feasibility of the project. The impact of depreciation on cash flows, including its indirect influence via the tax shield, is also discussed. The assignment also highlights the need for additional information, such as the inclusion of tax in project cash flows and the incorporation of depreciation tax shield within cash flows, to make a well-informed investment decision.

FINANCIAL INFORMATION FOR BUSINES
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1) One risk could relate to increase in the cost capital for the project which would adversely
impact the viability of the proposed machine. In order to mitigate this risk, sensitivity
analysis ought to be considered to determine the underlying sensitivity of the key capital
budgeting techniques such as NPV to the changes in the cost of capital. This will provide
information to the management with regards to the extent of adverse cost of capital
movement that the project can withstand (Damodaran, 2015).
Another risk could relate to uncertainty regarding the future estimates of inflows if there is
any drastic change in the business environment which may not have been considered. In
order to incorporate the same, scenario analysis is a useful tool. In this, cash flow estimates
are worked out in the optimistic, base and pessimistic case along with highlighting the
underlying probabilities of occurrence of these scenarios. Then, based on the respective
probabilities of each scenario, a weighted NPV is worked out to see if this is positive or not
(Petty et. al., 2015).
2) The requisite cash flow time line is indicated as shown below.
3) Annual depreciation expense = (Initial Cost – Salvage Value)/Useful life
Based on the given information, initial cost of machinery = $ 106,250
Salvage value or residual value of the equipment at the end of the project = $15,000
Total useful life of the machinery =6 years
Hence, annual depreciation expense for the proposed machine = (106250-15000)/6 = $
15,208.33
4) The relevant formula for ARR is indicated below.

ARR = [(Total profit during the project useful life/Project Useful life)/Average
investment ]*100
In order to estimate the total profit during project useful life in context of the given machine,
the cumulative project cash flows table is indicated below.
From the above, total profit during project useful life = $ 25,650
Project Useful life = 6 years
Average investment = $ 106,250
Hence, ARR = [(25650/6)/106250]*100 = 4.02%
5) Payback period refers to the time required to recover the original investment (Parrino &
Kidwell, 2014). In order to estimate the payback period in context of the given machine, the
cumulative project cash flows table is indicated below.
From the above table, it is apparent that the cumulative project cash flows are negative in
year 4 and become positive in year 5, hence payback period would lie between 4 and 5 years.
Payback period = 4+ (5600/15625) = 4.358 years

6) NPV(Net Present Value) refers to the sum of the present value of all the project net cash
inflows and outflows arising during the project’s useful life (Brealey, Myers & Allen, 2014).
The net cash flow for the proposed machine in every year is already available. Also, it is
known that the cost of capital is 10%. Thus, the NPV can be computed as shown below.
NPV = -106,250 + (32500/1.1) + (28750/1.12) + (23150/1.13) + (16250/1.14) + (15625/1.15) +
(15625/1.16) = -$ 5,930.51
From the above computation, it is apparent that proposed machinery NPV is -$ 5,930.51.
7) IRR may be defined as the discount rate which tends to lead to NPV as being zero
(Damodaran, 2015). Let the IRR for the proposed machinery be r%. Considering the IRR
definition, the following relationship would be true.
0 = -106,250 + (32500/(1+r)) + (28750/(1+r)2) + (23150/(1+r)3) + (16250/(1+r)4) +
(15625/(1+r)5) + (15625/(1+r)6)
Solving the above equation, we get r=7.74%
From the above computation, it is apparent that proposed machinery IRR is 7.74%.
8) Ronald should not invest in the proposed machinery owing to the following reasons (Petty
et. al., 2015).
 The ARR of the project is lower than the minimum 14% hurdle rate that the company
expects.
 The payback period of the project is higher than the expected 4 years.
 The NPV of the project is negative and hence the proposed machine would lower the
firm value and destroy wealth for shareholders.
 The IRR of the project is lower than the cost of capital (10%) which is not acceptable.
The above evidence hint towards the project not being financially feasible and therefore
Ronald should not make investment in the proposed machinery.

9) It is noteworthy that although depreciation is a non-cash charge, it has significant indirect
influence on the net cash flows owing to the tax shield that it offers as it tends to lower the
taxable profits. Thus, by lowering the net tax outflow, depreciation helps in enhancing the
cash flow. With regards to the proposed machinery, the effect of depreciation would tend to
enhance the overall cash flows on account of the tax shield (Parrino & Kidwell, 2014).
However, in the given case since it is known that income tax effect ought to been ignored,
hence depreciation does not impact any computations from 4-7.
10) Two pieces of additional information which would be required to decide if investment in
the proposed machinery would be made or not are indicated below (Petty et. al., 2015).
 The estimated project cash flows tend to include the influence of tax or not as in
capital budgeting post tax cash flows need to be considered. This is imperative since
post tax cash inflows are typically lower than pre-tax cash inflows and tend to impact
the project viability.
 Another key information which is missing is whether the impact of depreciation in
terms of tax shield has already been incorporated in the estimated cash inflow
information that has been provided for the project.
The current analysis has been performed assuming that the cash flows provided are post tax
and hence include the impact of depreciation tax shield.

References
Brealey, R. A., Myers, S. C. & Allen, F. (2014) Principles of corporate finance, 6th ed. New
York: McGraw-Hill Publications
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. & Nguyen, H. (2015).
Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education,
French Forest Australia