Appraisal of a capital expenditure project Essay

Appraisal of a capital expenditure project - Essay Example The three projects have different implications on the number of people needed to operate the machines, and vary in costs and capacity. Evaluating Capital Expenditures Choosing among capital expenditure projects should not rely solely on financial assessment. It is also important to undertake a subjective evaluation of each of the projects, in terms of its suitability for the macro-environment. An examination of the PEST (political, economic, social, and technological) conditions will determine which of the firms, if any, must be excluded by environmental conditions, or which would prove exceptionally suitable to these conditions. A risk assessment is another pre-requisite to determine which of the projects may pose extraordinary or undue risk for the company or the workers who shall be involved in the installation or operation of the new machinery. Incremental analysis shall be employed in this study, which requires discounting the existing financial data reflected by current operati ons, and instead rendering judgment based on the analysis of changes introduced by each project. Incremental analysis includes only the financial data that would vary in the future as a result of adopting each of the possible alternatives; all current data that are foreseen to remain unchanged are not included in the analysis (Weygandt, Kimmel & Kieso, 2010, p. 299). The accounts that appear in the next tables are the changes expected, based on estimates by the principal owners of the corporation, spouses Bill and Terry Anderson. Alternative projects Project A involves the purchase of a machine, the price and installation of which amount to 110,000 during year 0. This capital expenditure is depreciated over the life of the project, which is 8 years, and since there is no salvage value the annual increase in depreciation expense is 13,750, using the straight line depreciation method. The project mechanises some of the production functions, and as a result of adopting this Project, fe wer people will need to be hired. This results in a corresponding reduction in labour expense that gradually increases through the years as the operation becomes more efficient. Adoption of Project A does not foresee any change in revenues, cost of sales or operating expenses, other than the change in depreciation and labour expenses. The incremental accounts pertaining to Project A are shown in the next two tables. Since the increase in depreciation expense and decrease in labour expense have a cumulative effect on the net taxable income, there is a change in net income after tax after application of the 30% income tax rate. If the depreciation expense, which is a non-cash expense, is added back into the net income after tax, then the cash flow resulting from the adoption of Project A is obtained. The cash flow stream for the duration of Project A shall be used in the non-accounting capital expenditure assessment techniques Similarly, the incremental accounts for Project B are show n in the next two tables. Project B has a much smaller purchase and installation cost of 45,000 which comprises its initial investment. The resulting change in depreciation expense is an increase of 4,500 per year for the 10 years that constitute the life of Project B, using straight-line depreciation method. Project B has an assumed increase in revenues, owing to the fact that the business