FIN370 Capital Budgeting

# FIN370 Capital Budgeting - Capital Budgeting 1 Running...

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Capital Budgeting 1 Running Header: CAPITAL BUDGETING Capital Budgeting FIN/370 Team Assignment – Chapter 10 – Capital Budgeting [Note:  This problem is similar to the Raymobile Scooters example in Table 10-7] ABC Corporation is considering the introduction of a new product. The project will last five years and then be terminated. The company’s marginal tax rate is 34%.

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Capital Budgeting 2 The company’s cost of capital is 15%. The cost of the new plant and equipment for the project is \$7,900,000. Shipping and Installation costs are \$100,000. Projected sales are: Year              Units Sold     1 40,000 2 90,000 3 110,000 4 50,000 5 30,000 Sales price per unit: \$300 per unit in years 1-4, \$260 per unit in year 5. Variable cost per unit: \$180 per unit. Annual fixed costs: \$200,000. Initial Working Capital required is \$100,000 to start the project. Or each year, the total investment in net working capital will be equal to 10% of the dollar value  of sales for that year.  Thus, the investment in working capital will increase in years 1-3, and  decrease in year 4.  All working capital is liquidated at the termination of the project at the end of  year 5. Depreciation method:  Use simplified straight-line depreciation over five years.  It is assumed  the plant and equipment will have no salvage value at the end of the project. Based on the above information, answer the following question: 1. Should ABC Corporation focus on cash flows or accounting profits in making our  capital-budgeting decisions? Should we be interested in incremental cash flows,  incremental profits, total free cash flows, or total profits? In making capital budgeting decisions, it is best to focus on cash flows and not accounting profits because cash flows provides a more accurate measure of a firm’s wealth or value. Cash flow is considered to be the actual money on hand that can be reinvested by the firm. Cash flows reflect the correct timing of the benefits and cost of an investment and the after-tax cash flow is of particular interest because this is the cash that is actually available to the stockholders. Accounting profits, on the other hand, is earned by the company and not the money actually on hand (Principle 3 of Financial Management – Cash, not profit, is king).
Capital Budgeting 3 The item of interest when making capital budgeting decisions would be the incremental cash flow. The incremental cash flow is the difference between the cash flow if the project was taken on compared to the cash flow if the project was not taken on. (Principle 4 of Financial Management: Incremental Cash Flows – It’s only what changes that count). By focusing on the

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## This note was uploaded on 08/22/2011 for the course BUS 415 taught by Professor Barnes during the Spring '11 term at Coastal Carolina University.

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FIN370 Capital Budgeting - Capital Budgeting 1 Running...

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