Rejection of the proposed project by the Company
Through the analysis of the future cash outflow from the proposed project using the weighted average cost of capital of the company (WACC), it is found that an amount of $ 4,236,990 negative cash outflow will have incurred over total cash outflow from the project.
The present value of inflow from the proposed project for the future six years gives rise to an amount of $13,251,010. When taking the present value of scrap value of the proposed project for an amount of $ 8,000,000 at the end of the sixth year it derives a present value of $4,512,000. By adding the present value of scrap with the present value of net cash inflow the total amount arrived at, is $17,763,010. The initial investment required on the project amounts to $22,000,000.
When comparing the present values of inflow and outflow relating to the proposed project, it follows that a negative amount of $ -4236990 will have incurred on the project by the company at the end of the sixth year if it is adopted. Thus it is beneficial for the company to exclude the proposed project on the ground that the proposed project would not increase the share value of this company in the future.
For the computation of the net present value of the proposed project, the weighted average cost of capital is taken as the base. WACC is the required rate of return on the investment for maintaining the shareholders’ value at a constant level. The WACC is assumed as 10 % and the present value factor of 10 % is applied with the future cash inflow from the project. This method is adopted for addressing the issues concerned with the growing inflation rate in the future US economy. By taking the present value of future cash flow, a real estimation of the inflow of cash from the proposed project in the light of the existing inflation rate is made.
(d) In light of the rising concern about inflation in the coming years, what adjustments should be made to either the cash flow or to the cost of capital? Explain your answer.
Growing inflation rates will affect investment decisions of business concerns. When the anticipated inflation rate on future cash flow is changed it will affect the estimated cash flow from the project.
Adjustments in cash flow with increasing inflation rate
Cash flow is the economic income derived from the investment. For measuring the profitability of investment, managers take the difference between initial investment and future cash inflow expecting from the investment. The present value of net cash flow from the project is deducted with the initial investment required for profitability measurement relating to the project. (Fletcher).
For incorporating the projected inflation rate on the calculation of future cash flow from the proposed project, it must take the present value of the inflow by applying the corresponding forecasted future inflation rate. Nominal cash flows from a project should be compared with its nominal cost of capital.
“In the United States, nominal interest payments are treated as tax deductions by businesses and taxable income by investors, capital gains are taxed without an adjustment for inflation, and depreciation is written off on a historical cost basis.” (Cohen, Hassett and Hubbard, p. 199).
In the case of a constant rate of inflation in the economy, the rates of return from investments are equal to the stated or nominal rate of interest.
In an inflated economy, the return from the investment will be different from the real return. Thus the future cash flows have a lower purchasing power compared to its book value. (Mills. P. 80).
Since capital projects yield returns over a number of years the correct assessment of its profitability can be made only if the annual returns of future years are brought to their respective PV.
NPV method is helpful to evaluate investment proposals in present value concepts. The time value of money is taken under this method and thus claims that cash flow arising at different periods differs in value and is comparable only when their present values (PV) are found out.
Thus in order to avoid inflation rate impacts on the company’s investment, while calculating the actual value of cash inflow from a project it has to take the present value of the future inflow by multiplying the future cash flows with the corresponding PV factor.
Cohen, Darrel., Hassett, Kevin A., and Hubbard, R. Glenn. Inflation and the User Cost of Capital: Does Inflation Still Matter? 2008. Web.
Fletcher, Howard. Cash Flow Planning and Modelling: Income Versus Cash Flow. Stronghold Capital Partners. 2008. Web.
Mills, Geofrey T. The Impact of Inflation on Capital Budgeting and Working Capital: The Cost of Capital and Inflation. Journal of Financial and Strategic Decisions. 2008. Web.