Finance

Part B1. Identify what the correct net cash flow for the second year would be if all cash expenses were as described in the scenario but there were no depreciation expense.

The net cash flow for the second year is 589,000 and the depreciation expense is 330,000. If depreciation expense is excluded from the expenses, then the EBT would be 700,000 and net income would be 210,000. Since there is no depreciation expense, no non cash expense will be added back to the net income in order to calculate net cash flow therefore, the net cash flow for second year would be  700,000. It should be mentioned here that the net cash flow is a sum of return on capital ( net income) and return of capital ( depreciation) hence, if depreciation is not included, the net cash flow analysis will be flawed.

a. Explain the impact of depreciation on net cash flow for the second year.
Analysis of this case makes it evident that depreciation expense impacts the earnings before taxes, income taxes paid and net income hence indirectly affects net cash flow. The depreciation expense gets added back to the net income to calculate net cash flow, therefore it can be assumed that depreciation does not affect net cash flow however, it is also observed that due to depreciation expense the net income is decreased which results in lower net cash flow.

2. Based upon your NPV analysis in part A2, make a recommendation to Person K regarding what decision to make. Explain why this is an appropriate action.

The evaluation of the given project based on NPV proves that Pearson K. should invest in the project, because as per the rule for selecting independent projects, NPV is positive (Brigham, 2007, p. 337). I am recommending this course of action because positive NPV means that the investment will be able to generate more cash than is needed in order to cover the initial investment made (Brigham, 2007, p. 338). The excess cash inflow from investment is actually given to shareholders and thus by investing in this project, the position of Pearsons shareholders would improve by 136,256. 3. Based upon your IRR analysis in part A3, make a recommendation to Person K regarding what decision to make. Explain why this is an appropriate action.

Based upon IRR analysis, Pearson should make the investment because IRR is 13.3 which is greater than 12 cost of capital for the company. This action is appropriate because IRR of a project is the expected rate of return of the project, hence if IRR is greater than the cost of capital which is the cost of funds invested, then the excess cash will add to the shareholders wealth (Brigham, 2007, p. 340)4. Explain why the accounting rate of return on this project is different from the internal rate of return for the same capital investment.

The accounting rate of return for this project is 19.4 which is different from IRR of 13.3. The difference in both the rates can be attributed to the fact that accounting rate of return employs the net income earned during each year and completely ignores the time value of money associated with investment (Mathur, 2003, p.188). However, IRR employs net cash flows which are generated each year. Therefore, both the returns are bound to be different because not only they take different values in consideration but their treatment of those values is also different.

5. Explain the relative significance of the unadjusted payback period in this decision situation.
Unadjusted payback period is the calculation of the number of years within which the total investment will be recovered. The basic advantage of this method is that it is simple and easy to show a breakeven point in the investment made. For the case in hand, the unadjusted payback period is 4 years and 7 months however, this method of investment evaluation is flawed because of the following reasons

Payback period does not take into account the time value of money which means that it assigns equal weights to all the inflows irrespective of their timing. Thus, cash inflow occurring during the 1st year is similar in value to the cash flow in the last year.

This method also ignores the cash inflows after the initial investment is recovered, which implies that it cannot measure the total profitability generated by investing in a project.

Payback period is incapable of proving that the investment will be able to add value to shareholders wealth, because shareholders wealth does not depend upon the time period taken for the investment to recover.

6. Explain how the weighted average cost of capital should be used in capital budgeting analysis when utilizing the NPV method.

Weighted average cost of capital is the cost of the funds that a company invests in a project. For accepting a project based upon NPV evaluation method, the future cash flows are discounted at the cost of capital to calculate the present value of cash flows.

7. Explain how the weighted average cost of capital should be used in capital budgeting analysis when utilizing the IRR method.

Weighted average cost of capital is used as the hurdle rate when IRR method is utilized for investment evaluation. Hurdle rate is minimum rate which rate of return from investment must exceed so that the project can be accepted.