Investing In Capacity
In this Milestone, we apply tools, knowledge, and insight gained throughout this course. You will be required to:
Apply time value of money concepts to determine project value.
Assess a project’s expected cash flows.
Apply and interpret capital budgeting criteria, including Net Present Value, Payback Period, and Internal Rate of Return.
Apply cost-of-capital pricing formulas to assess financing options. Apply and interpret capital budgeting criteria.
Begin your analysis of acquisition by explaining why only some component costs of the firm are included when computing financing costs for this project, concentrating on the choice between a project/divisional cost of capital versus a firm-wide cost of capital approach. (max 400 words) [30 points]
2. Principles for Cash Flow Estimation
Consider one Complement sold within each franchise location and one Substitute establishment. (max 200 words) [20 points]
Because this CMS will represent an investment in fixed assets, explain whether this decision will change Operating Cash Flow (see Example 2.6 on p. 49 of our required text) and Free Cash Flow (see p. 49 of our required text). (max 100 words) [10 points]
Section B: Evaluate
Evaluation of Alternatives
Your evaluation of this potential acquisition requires you to select and apply investment decision rules. In this section, you are to present an evaluation of this acquisition based on an application of the decision rules selected and a summary of benefits and limitations of these capital budgeting techniques. (500 words max) [20 points]
Sample Solution
In evaluating the potential acquisition of a CMS, there are several decision rules that can be used to assess its value. The most commonly utilized capital budgeting techniques include Net Present Value (NPV), Payback Period (PP), and Internal Rate of Return (IRR).
Net Present Value (NPV) is a method for assessing the value of an investment by calculating the present value of all projected cash inflows, minus the initial capital outlay. By comparing this net amount with a required rate of return, NPV provides an indication as to whether or not it would be beneficial to pursue this project.
The Payback Period method considers how long it will take for the initial capital outlay to be repaid from cash flows generated by the project. This approach has been criticized due to its inability to consider future cash flows post-payback period and therefore does not provide an accurate assessment regarding whether or not an investment should be pursued.
Internal Rate of Return is a metric used for measuring profitability which compares estimated future cash flows against capital invested in order to determine a rate at which these inflows and outflows break even over time. IRR takes into consideration all associated costs such as taxes and financing costs, making it useful when considering larger investments such as those involving acquisitions.
Each decision rule carries both benefits and limitations that have implications on its application in certain cases; however they all provide valuable insight when considering the potential viability of any given investment opportunity – including acquisitions like this one – providing decision makers with data-driven guidance when weighing their options.