Question

please answer the question by explaining the step by step process used in the calculation. and please discuss the results. thank you:)

Please set-up solution model for the following capital budget problem. Explain the approach you plan to take and why. Then, please perform the calculations of your model and draw conclusions.

Capital Budget Problem:

This case continues following the new project of the WePPROMOTE Company, that you and your partner own. WePROMOTE is in the promotional materials business. The project being considered is to manufacture a very unique case for smart phones. The case is very durable, attractive and fits virtually all models of smart phone. It will also have the logo of your client, a prominent, local company and is planned to be given away at public relations events by your client.

More details have emerged and your estimates are becoming more precise.

The following are the new values to the data that you have been estimating up to this point:

• You can borrow funds from your bank at 3%.
• The cost to install the needed equipment will be $105,000 and this cost is incurred prior to any cash is received by the project.
• The gross revenues from the project will be $25,000 for year 1, then $27,000 for years 2 - 4. Year 5 will be $23,000.
• The expected annual cash outflows (current project costs) are estimated at being $13,000 for the first year, then $12,000 for years 2, 3, and 4. The final year costs will be $10,000.
• After 5 years the equipment will stop working and will be worthless.
• The discount rate you are assuming continues to be 6%.

Calculate the net present value, and determine whether the project is worth doing from a financial perspective.

Answer 1

To solve a capital budgeting problem, we need to calculate net cash inflows from the project during the project life cycle. Net cash inflow is equal to the cash inflows minus cash outflows.

After calculation of net cash inflows, we need to discount it at appropriate rate to find out present value of the cash flows. Discount rate in the given question is 6%. We need to figure out the discounting factors using the appropriate discount rate. Formula to calculate discounting factor is (1+discount rate)^n. Where, n is the year for which we are calculating discount rate. Suppose discount rate is 6% and we need to calculate discounting factor for year 5. Then discounting factor for year 5 = (1+0.06)^5= 1.3382256.

After calculating the discounting factor, we need to divide the net cash outflows by the discounting factor to get present value of all the future cash flows.

When we add all the present value of future cash flows, we get the Net Present Value(NPV) of the Project.

If NPV>0, then project should be accepted, else, project should not be accepted. The given problem is calculated as below. We assumed that bank interest on initial cash outlay of $105000 @3% is paid equally using simple interest and no repayment of loan made during the project life.

Since the NPV of the Project is negative, we should not accept this project.