Question

Imagine yourself to be a corporate executive in charge of deciding whether or not your company should go ahead building this factory your production people have been talking about for a while. Keeping in mind the time value of money, how would you go about making that decision?

Answer 1

Answer:

Building factory is a capital budgeting decision. This involves investment of substantial amount of money wherein benefits will flow on number of years. Such decision involves long term commitments of investment and most of the times once implemented it is difficult to withdraw without substantial losses. As such, such decisions need careful evaluation before implementation. It is essential to do project evaluation in terms commercials as whether implementation of project will add value to shareholders. As benefits flows over number of years, it is essential that project evaluation factors in time value of money.

To do commercial evaluations:

1. Estimate the capital investment required including any increase in working capital required.

2. Estimate useful life of the project.

3. Calculate cost of capital / WACC

4. Forecast incremental sales, expenses and incremental benefits net of tax. Estimate depreciation tax shield. From these input numbers get annual cash flows.

5. Find discounted cash flows factoring in time value of money.

6. Calculate net present value.

7. If net present value is positive accept the project else reject it.

8.There are other techniques such as 'Internal rate of return (IRR)' which can also be used to evaluate. IRR technique also factors in time value of money. In case IRR is used accept the project if IRR is greater than cost of capital. If IRR is less than the cost of capital, then reject the project.