Question

Choice 2: Capital Budgeting Decision Since LSUS corporation is producing at full capacity, Amanda has decided to have Han examine the feasibility of a new manufacturing plant. This expansion would represent a major capital outlay for the company. A preliminary analysis of the project has been conducted at a cost of $1.6 million. This analysis determined that the new plant will require an immediate outlay of $54 million and an additional outlay of $31 million in one year. The company has received a special tax dispensation that will allow the building and equipment to be depreciated on a 20-year MACRS schedule. For Property Placed in Service after December 31, 1986 Recovery 3-Year 5-Year 7-Year 10-Year Year (200% DB) (200% DB) (200% DB) (200% DB) 20-Year (150% DB) 33.33 4445 1481 20.00 32.00 19.20 11.52 11.52 5.76 14.29 24.49 1749 1240 10.00 18.00 14.40 11.52 9.22 7.37 6.55 6.55 15-Year (150% DB) 5.00 9.50 8.55 7.70 6.93 6.23 5.90" 5.90 5.91 5.90 5.91 5.90 5.91 656 3.750 7.219 6.677 6.172 5.713 5.285 4.BBB 4.522 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 2.231 5.90 5.91 2.95 Switchover to straight-line depreciation Because of the time necessary to build the new plant, no sales will be possible for the next year. Two years from now, the company will have partial-year sales of $17 million. Sales in the following four years will be $28 million, $37 million, $40 million, and $43 million. Because the new plant will be more efficient than LSUS corporation's current manufacturing facilities, variable costs are expected to be 65 percent of sales, and fixed costs will be $2.4 million per year. The new plant will also require net working capital amounting to 8 percent of sales for the next year. Han realizes that sales from the new plant will continue into the indefinite future. Because of this, he believes the cash flows after Year 5 will continue to grow at 2.5 percent indefinitely. The company's tax rate is 40 percent and the required return is 12 percent.

1) Amanda is not sure about the capital budgeting technique and want like Han to elaborate clearly what are and are not important elements to engage the capital budgeting decision for the LSUS corporation.

Answer 1

Capital budgeting techniques are used for selecting the investment projects. their are no of techniques available

Traditional or non discounting

1) Payback Period

2) Accounting ate

Tme adjusted or Discounted cash flow

1) Net present value

2) Profitability index

3 ) Internal rate of return

4 ) Modified internal rat e of return

5) Discounted Payback

Capital budgeting decision is taken on the basis of cash inflows to the organisation from the investment. Cash Inflows are calculated from sales minus expenses it does not considers Tax and working capital , depreciation .

Calculation of discounted cash inflow

	Year 1 (in Millions)	Year 2 (in Millions)	Year 3(in Millions)	Year 4(in Millions)	Year 5(in Millions)
Sales	17	28	37	40	43
Less Variable cost	11.05	18.2	24.05	26	27.95
	5.95	9.8	12.95	14	15.05
Less fixed expenses	2.4	2.4	2.4	2.4	2.4
	3.55	7.4	10.55	11.6	12.65
Required rate of return @12%	0.893	0.797	0.711	0.635	0.567
NPV @12%	3.170	5.898	7.50	7.377	7.17

Calculation of Net present value

	Amount (in Millions)
Discounted cash inflows	31.115
Less Cash outflows	54
outflow after one year( 31*0.893)	27.68
NPV	(50.56)