Jamie Williams, the project manager of Arc Systems Ltd. is evaluating a proposal to install solar panels on the roof of its factory. The panels will cost $150,000 per set. Depending on the price of electricity and the efficiency of the panels, the project will increase operating cash flows by either $50,000 per year or $75,000 per year. The useful life of the panels is 5 years. If early results indicate savings of $75,000 per year, four additional sets of panels will be installed immediately at the same cost with the same projected savings. The probability of either outcome is 50%. Using a discount rate of 10%: Required: i. Compute the expected NPV of the project if the option to expand is NOT considered. ii. Compute the expected NPV of the project if the option to expand is considered. iii. Why is it important to consider real options in the capital budgeting process? Give ONE (1) specific example.
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
Jamie Williams, the project manager of Arc Systems Ltd. is evaluating a proposal to install solar
panels on the roof of its factory. The panels will cost $150,000 per set. Depending on the price of
electricity and the efficiency of the panels, the project will increase operating cash flows by either
$50,000 per year or $75,000 per year. The useful life of the panels is 5 years. If early results
indicate savings of $75,000 per year, four additional sets of panels will be installed immediately
at the same cost with the same projected savings. The probability of either outcome is 50%. Using
a discount rate of 10%:
Required:
i. Compute the expected NPV of the project if the option to expand is NOT considered.
ii. Compute the expected NPV of the project if the option to expand is considered.
iii. Why is it important to consider real options in the capital budgeting process? Give
ONE (1) specific example.
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