Capital Budgeting - Lite orange juice Project
Assessment: Lite orange juice Project
1. Define the term “incremental cash flow”. Since the project will be financed in part by debt, should the cash flow analysis include the interest expense?
Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company 's cash flow will increase with the acceptance of the project.
Cash flow analysis should not include the interest expense. We discount project cash flows with a cost of capital that is the rate of return required by all investors. Interest expenses are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.
2. Suppose another juice producer had expressed an interest in leasing the lite orange juice production site for $25,000 a year. If this true, how would this information be incorporated into the analysis?
This information would cause a slight change in the decision-making process. More specific, we would not recommend realizing the project if the average net profit per year (including the cost of capital) will be less than or equal to $25,000 which in fact can also be achieved with no risk at all. In order to recommend realizing the project we should either be certain that our profit will be higher than our opportunity cost ($25,000), or have no better alternative to invest the company’s capital. Of course the above are valid only if there is no cannibalization effect to our sales from the other’s producer’s activities. In the case that we accept the leasing proposal, assume an agreement for 4 years and receive the payment at the end of each period, we have a NPV of $75,933, which is lower than the NPV of our project which is $1,203,759. So, assuming equal life of the projects and no other side-effects, we would prefer to go on with the Lite project and not to lease the production.
The fact that we decide to go on with the
1. Define the term “incremental cash flow”. Since the project will be financed in part by debt, should the cash flow analysis include the interest expense?
Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company 's cash flow will increase with the acceptance of the project.
Cash flow analysis should not include the interest expense. We discount project cash flows with a cost of capital that is the rate of return required by all investors. Interest expenses are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.
2. Suppose another juice producer had expressed an interest in leasing the lite orange juice production site for $25,000 a year. If this true, how would this information be incorporated into the analysis?
This information would cause a slight change in the decision-making process. More specific, we would not recommend realizing the project if the average net profit per year (including the cost of capital) will be less than or equal to $25,000 which in fact can also be achieved with no risk at all. In order to recommend realizing the project we should either be certain that our profit will be higher than our opportunity cost ($25,000), or have no better alternative to invest the company’s capital. Of course the above are valid only if there is no cannibalization effect to our sales from the other’s producer’s activities. In the case that we accept the leasing proposal, assume an agreement for 4 years and receive the payment at the end of each period, we have a NPV of $75,933, which is lower than the NPV of our project which is $1,203,759. So, assuming equal life of the projects and no other side-effects, we would prefer to go on with the Lite project and not to lease the production.
The fact that we decide to go on with the