Finance

Question 12-12

The need of increasing investment costs to attain real options primarily stems from the opportunity provided by such options . Real options hold the right but not the obligation to the business enterprise to undertake additional actions in the future in to improve the cash flow of the project at hand . Real options are thus valuable for the organization even though costly . For instance , a type of real options encompasses abandonment . The right to abandon the capital project during its operation life diminishes the investment risk and enhances the envisaged

profitability . This thus leads to its feasibility

Problem 12-7

a ) The 5 ,000 spent last year on the project at hand should be considered as a sunk cost . Such cost has no relevance for the new project analysis since it is already incurred and cannot be recouped In this respect it should not be considered when evaluating the project because only incremental costs and revenues are the pertinent costs that will be taken into account

b ) Base price of new milling machine 108 ,000

Shipping and Installation Costs 12 ,500

Increase in Working Capital 5 ,500

Cash Outflow arising from New Machine 126 ,000

c ) Depreciation of Machine under MACRS

Capital Expenditure of Machine 108 ,000 12 ,500 120 ,500

Depreciation in Year 1 120 ,500 x 33 39 ,765

Depreciation in Year 2 120 ,500 x 45 54 ,225

Depreciation in Year 3 120 ,500 x 15 18 ,075

Salvage Value

Cost of Machine 120 ,500

Accumulated Depreciation 112 ,065

Disposal Value 65 ,000

Profit on Disposal 56 ,565

Corporation Tax

Year 1 2 3

Increased Cash Inflow 44 ,000 44 ,000 100 ,565

Depreciation 39 ,765 54 ,225 18 ,075

Profit before taxation 4 ,235 (10 ,225 ) 82 ,490

Taxation 35 1 ,482 0 28 ,872

Operating Cash Inflow

Year 1 2 3

Increased Cash Inflow 44 ,000 44 ,000 114 ,500

Corporation Tax 1 ,482 0 28 ,872

Operating Cash Inflow 42 ,518 44 ,000 85 ,628 d ) Disposal Value of Milling Machine 65 ,000

Decrease in Labor Costs 44 ,000

Investment in Working Capital 5 ,500

Terminal Year Cash Flow 114 ,500

e ) Net Present Value of Machine

Year 0 1 2 3

Cash Inflow /Outflow (126 ,000 ) 42 ,518 44 ,000 85 ,628

Discount Factor 12 1 0 .89286 0 .79719 0 .71178

Present Value (126 ,000 ) 37 ,963 35 ,076 60 ,948 Net Present Value 7 ,987

Based on the financial figures computed above the new machine should be purchased because it is financially viable . A positive net present value will arise in its three years of operation

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