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.

2) Amanda is recommended to use profitability index, NPV, and IRR, she wants Han to examine extensively the benefits and drawbacks of each approach

Answer 1

Ans. Beneilits of NPVP NPV satisfied basic eriterion for project evaluation en it considere time value of money 2 All the cash flows are converted into present value so it eas are actual value created in terme of curreny 3) By adjusting cost of capital, project with are ako "Heken into consideration _Draw back of_NPL :D To estimate cash flow & Coct of capital is difficult in practice & the accuracy of NPV depende on _these Hwo factoxin 35 while comparing mutually excursive project, it does not consider difference in inital outflows, size of different proposals etc - Benefits of IRR D Time valie_is_taken into account 27 IRA consider all the cash inflows, arise at different points of time 3) A IRR method doean't require calculation of cost of capital, so simple to use k extimate." Draw back of_JRR ___ All there is multiple IR Rey then decision making ويقع محل 25 The gusumption of cath_inflowl of a proposal are reinvedted, is not practically possible 31 90 compare mutually exclusive project, it i no1.worth L eren

Benefits of PI - y Helps in ranking projects, if NPV is positive 2) In scaucity of funds, it is helpful in case of investment in divisible projects Drawback of PI & 1) Where there is multiple proposal as mutually exclusive) with different patters of invertment, Pl doesn't work. I 27 70 estimate cost of capital is complex task As we see in above decision, Amanda bar to we all. three methode IRR considere all cash inflows of in every year there is change in sales, came is taken into consideration while calwlating NPV After á you if the cash flows increases at 2.5% then NPV is. positive which helps in calculating Pl of project