Financial Analysis and Capital Budgeting: A Comprehensive Guide

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Assessment Item 3

Table of Contents
Question 1...................................................................................................................................................2
Question 2...................................................................................................................................................6
Question 3...................................................................................................................................................7
References.................................................................................................................................................10
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Question 1
Incremental cash flow
In capital budgeting, the incremental cash flow is considered to be net after-tax cash flow which
a project generates over its life.
Formula:
Incremental Cash flows = Cash Inflows − Cash Outflows − (Inflows − Outflows − Depreciation)
× Tax Rate
Calculation
Annual cash flow: 511500
Calculation:
Annual sales 5000
Rate 2.3
Annual sales 11500
Sales of
accessories
500000
Total annual
sales
511500
Total assets life: 20
Enter tax rate percent: 30%
Annual Expense:
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Operating expense is considered to be taken as 60% of the total revenue. The annual revenue
was 511500. Therefore the total annual expense will be 60% of 511500.
Annual expense
Operating
expense
60% of the annual
revenue
Operating
expense
306900
Initial investment: $30 million
Additional investment: $2 million
Company tax rate: 30%
Depreciation calculation on straight line method
Depreciation per year =
Asset Cost - Salvage Value
Useful life
Year
Beginning
Book Value
Depreciation
Percent
Depreciation
Amount
Accumulated
Depreciation
Amount
Ending Book
Value
1. $32,000,000 5.00% $1,500,000 $1,500,000 $30,500,000
2. $30,500,000 5.00% $1,500,000 $3,000,000 $29,000,000
3. $29,000,000 5.00% $1,500,000 $4,500,000 $27,500,000
4. $27,500,000 5.00% $1,500,000 $6,000,000 $26,000,000
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5. $26,000,000 5.00% $1,500,000 $7,500,000 $24,500,000
6. $24,500,000 5.00% $1,500,000 $9,000,000 $23,000,000
7. $23,000,000 5.00% $1,500,000 $10,500,000 $21,500,000
8. $21,500,000 5.00% $1,500,000 $12,000,000 $20,000,000
9. $20,000,000 5.00% $1,500,000 $13,500,000 $18,500,000
10. $18,500,000 5.00% $1,500,000 $15,000,000 $17,000,000
11. $17,000,000 5.00% $1,500,000 $16,500,000 $15,500,000
12. $15,500,000 5.00% $1,500,000 $18,000,000 $14,000,000
13. $14,000,000 5.00% $1,500,000 $19,500,000 $12,500,000
14. $12,500,000 5.00% $1,500,000 $21,000,000 $11,000,000
15. $11,000,000 5.00% $1,500,000 $22,500,000 $9,500,000
16. $9,500,000 5.00% $1,500,000 $24,000,000 $8,000,000
17. $8,000,000 5.00% $1,500,000 $25,500,000 $6,500,000
18. $6,500,000 5.00% $1,500,000 $27,000,000 $5,000,000
19. $5,000,000 5.00% $1,500,000 $28,500,000 $3,500,000
20. $3,500,000 5.00% $1,500,000 $30,000,000 $2,000,000
Incremental cash flow calculation
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Annual cash inflow: 511500
Annual expense: 306900
Depreciable amount asset: 1500000
Asset Life: 20 year
Tax rate: 30%
A business has the following project details:
Annual Cash Inflows: 511,500.00
Annual Expenses: 306,900.00
Depreciable Amount: 1.00
Asset Life: 20
Tax Rate: 20%
Calculate the incremental cash flow items Incremental Cash flows = Cash Inflows − Cash
Outflows − (Inflows − Outflows − Depreciation Expense) × Tax Rate
Calculate Depreciation Expense (Straight Line Method):
Depreciation Expense = Depreciable Amount of Asset/ n
Depreciation Expense = 1,500,000/20
Depreciation Expense = 0.05
Calculate Taxes per Year:
Taxes per Year = (Inflows − Outflows − Depreciation Expense) × Tax Rate
Taxes per Year = (511500 − 306900 - 0.05) × 30%
Taxes per Year = (204599.95) × 30%
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Taxes per Year = 61,379.99
Calculate Incremental Cash Flows:
Incremental Cash flows = Cash Inflows − Cash Outflows – Taxes
Incremental Cash flows = 511,500.00 − 306,900.00 – 61,379.99
Incremental Cash flows = 143,220.02
Based on the incremental cash flow, it helps to provide a capital budgeting decision which needs
to project the cash flow into the future. Further, the time value of money is considered to be the
method to determine and identify whether the project is profitable or not. Based on the value
which is obtained from the incremental cash flow, it is evident that the project reflects positive
value. This helps to make the decision process easy and convenient for the company. The project
life was around 20 years with the initial cash outflow being at $30 million with an additional $2
million invested make the total initial investment at $32 million. This reflects that the
depreciation amount will be levied on $32 million. The $2 million will be recovered at the end of
20 years. The tax rate of the company will be around 30% which makes the taxes per year is
61,379.99. on further calculation with the help of formula of incremental cash flows which
states cash inflows minus cash outflows minus taxes leads to the detect and determine the project
life. The incremental cash flow value states 143,220.02 which is considered to be favorable for
the project to give a positive sign (Tehranian, 2017).
Question 2
a) WACC = (E/ V * Re) + {(D/V * Rd * (1-Tc)}
D = Market value of the firm’s debt = 307m
E = Market value of the firm’s equity = 40m
V = E + D = 347m
Re = Cost of equity = 30.8m
Rd= cost of debt = 292m
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Tc = Corporate tax rate = 30 %
WACC = 110.923%
b) After-tax cost fir debt = ( 1- tax rate ) * cost of debt
(1 – 30%) * 292
0.7 * 292 = 204.4
After-tax cost fir equity = (1- tax rate) * cost of equity
(1 – 30%) * 30.8
= 21.56
c) Market value of the debt = number of outstanding debt * current market price = 300000 *
1024.87 = $307461000
Market value of the equity = 2000000 * 20 = $40000000
d) The after-tax weighted average cost of capital = total market value of debt and equity * (1- tax
rate)
= 347461000 * (1- tax rate)
= $243222700
Question 3
Short term finance like trade finance usually incorporates collateral for example inventory or
accounts payable. It is also known as the working capital financing which is used by the
company during the period of uneven cash flow. The company is using these processes during
the variation in the seasonal patterns seen in businesses. The company is using the inventories
and the account receivables for the purpose of ordering the business which is financed by the
company. The most important part is that in the form of the small period normally less than the
year. The invoicing discounting processes are also included by the companies for the third
parties involved in the business. Apart from this, the factoring arrangement is similar for the
company as the invoicing process is maintained for the third parties involved with the company.
The trade credit is found to be extending the accounts payables with including the trade
processes. The company would sell its receivables towards their creditors for instant cash.
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Corporate loans mainly target a particular purpose like purchase or construction of equipment,
loans for short term like working capital loans. The most common short term loan is analyzed as
a payday loan (Arjunan, 2017). This type of loan provides the borrower cash until they wait for
their period for next payment. This type of loan mainly requires payback at the appointed time.
The usage of short term loan could be identified as an expensive source of finance for fulfilling
the requirements of long term projects. This is for the reason of long term loan that locks down
the current rate of interest. Throughout the general economic times, the rate of interest often
rises. The company would be more likely to pay a greater rate of interest as the company makes
a sequence of short term debt in order to finance its project of long term frame. Therefore this
enables to raise the project cost. On the other hand, this loan could be borrowed by the borrower
more quickly. The line of credit facilitates in borrowing as well as reborrows the money equal to
the limit of credit. The short term loans could be available from various sources like peer to peer
leaders and online (Bora, 2015). The peer to peer lean could be arranged through the website
where lender and borrower can come together as well as negotiate terms. The development of
different lending industries offers small businesses more opportunities for acquiring short term
debt. Thus the competition among the various lenders facilitates in keeping the rate of interest
comparatively low.
Trade credit portrays the credit that has been extended by the vendors of goods within the usual
business course. Trade credit is analyzed to be an important source of finance for a shorter period
of time. The business’s’ creditworthiness and the confidence of their supplier were analyzed as
the key securing trade credit. This credit is mainly granted upon the basis of open account
whereby the supplier transmits goods towards the purchaser to receive payment during the
upcoming period according to the sales invoice. When the payment is being delayed after the due
date according to the sales invoice terms then it is known as stretching accounts payable. The
firm might generate further funds for short term through stretching accounts payable. However,
they need to disburse penal interest charges (Bragg and Bragg, 2018).
Commercial paper is considered a short term credit. This is identified as an unsecured debt. This
source of fund is utilized to finance organizational operations. This is because the rates were
generally cheaper when compared with that of long term loan. The higher amount of risk could
not facilitate higher yields. The commercial paper is issued at discount from the face value and it
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reflects the market interest rates. An example of commercial paper could be identified as a retail
firm requires short term finance for their new inventory. Therefore the retailer requires $5
million for the commercial papers’ face value for exchange of finance. When the commercial
paper matures the retailer need to give $0.1 million of interest (Immagic, 2017). Therefore 1%
rate of interest could be adjusted for the period of time the commercial paper remains
outstanding.
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References
Arjunan, K. (2017). A new method to estimate NPV and IRR from the capital amortization
schedule and an insight into why NPV is not the appropriate criterion for a capital investment
decision. [online] researchgate.net. Available at:
https://www.researchgate.net/publication/316228193_A_new_method_to_estimate_NPV_and_I
RR_from_the_capital_amortization_schedule_and_an_insight_into_why_NPV_is_not_the_appr
opriate_criterion_for_capital_investment_decision [Accessed 6 May 2019].
Bora, B. (2015). COMPARISON BETWEEN NET PRESENT VALUE AND INTERNAL RATE
OF RETURN. [online] academia.edu. Available at:
https://www.academia.edu/20180443/Comparison_Between_Net_Present_Value_And_Internal_
Rate_Of_Return [Accessed 6 May 2019].
Bragg, S. and Bragg, S. (2018). The difference between NPV and IRR. [online] AccountingTools.
Available at: https://www.accountingtools.com/articles/the-difference-between-npv-and-irr.html
[Accessed 6 May 2019].
Immagic (2017). Internal rate of return. [online] Immagic.com. Available at:
https://www.immagic.com/eLibrary/ARCHIVES/GENERAL/WIKIPEDI/W120622I.pdf
[Accessed 6 May 2019].
Tehranian, H. (2017). INVESTMENT CRITERIA Capital Budgeting Decision. [online] bc.edu.
Available at: https://www2.bc.edu/hassan-tehranian/2017/Topic%2012%20Investment
%20Criteria.pdf [Accessed 6 May 2019].
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