Essay - Wacc 1) We Will Assume that the Old Machine is...


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WACC

*****) We will assume that the old machine is fully depreciated. This makes the tax burden on the disposal as $34,000. The depreciation expense on the new machine will reduce the tax burden, and ***** cost savings are assumed to translate directly to profit, which will increase the tax *****. The net effect is an increase in ***** burden from the ***** mach*****e of $37,400 per year, ***** subtracts from the cost *****, giving a net *****nual cash flow of $432,600. The net present value of ***** new machine therefore becomes $1,715,925.02. The present cash *****s are the outlay for the new *****, the proceeds from the ***** of ***** old machine and the tax on those proceeds. This *****tals $1,734,000. Therefore, the NPV ***** the purchase of the new machine is -$18,074.98. Theta Widgets should not ***** the new machine.

2) Capital budgeting decisions are complex. There are many variables ***** must be taken into consideration. Moreover, the information being used to make the decision is almost entirely based on estimates. The more accurate ***** inputs, the str*****ger the decision, but much of what goes into a capital budgeting decision is variable.

Inflation, for example, can have a significant impact on the outcome of the decision. For the most part, cost of capital reflects past conditions. There may be some element ***** future *****, but as soon as a variable such as inflation differs from the *****sumed rate of inflation, the figures changes. The cost of capital used to make the ***** has an assumed rate of inflation built ***** it. If the ***** of ***** increases, that cost of capital becomes obsolete. For this reason, companies should set a conserv*****tive hurdle rate that assumes ***** adverse movement in the rate of inflation. Even in doing so, most companies will bear the risk ***** a sharp spike in *****flation rates.

The future cash flows would, in theory, need to be discounted at a higher rate to reflect the change ***** inflation. ***** ***** adversely affect the ***** ***** of ***** cash flows. This in turn will reduce ***** present value of those flows, and can erode the positive net present ***** ***** was derived in order to ***** the investment decision in the first place. A firm ***** ideally ***** able to pass the inflation on ***** *****ir customers in ***** to balance off the deterioration in value of the cash flows.

***** ***** decisions are filled with uncertainty. There are several ways for a company ***** limit this uncertainty or build in safeguards against adverse consequences. The ***** is to get ***** best information possible prior to making an investment dec*****ion. The ***** ***** for future cash flows are going ***** be estimates, but some ***** ***** better than others. The higher the quality of the information in the first place, the more ***** your NPV calculations will be.

*****nother way to deal ***** ***** is to make conservative estimates. A project that only has a *****

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