Question:
The Stanton Stationery Shoppe wants to acquire The Carlysle Card Gallery for $450,000. Stanton expects the merger to provide incremental earnings of about $70,000 a year for 10 years. Carol Stanton has calculated the marginal cost of capital for this investment to be 8%. Conduct a capital budgeting analysis to determine whether she should purchase The Carlysle Card Gallery.
Answer:
Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year.
An organization has to take many decisions regarding the expansion of business and investment. To do that, they will require the help of NPV method and base its decision on the same.
Net present value is used in Capital budgeting to analyze the profitability of a project or investment. It is calculated by taking the difference between the present value of cash inflows and present value of cash outflows over a period of time.
As the name suggests, net present value is nothing but net off of the present value of cash inflows and outflows by discounting the flows at a specified rate.
From the question the following are given:
- Capital Expenditure = $450,000
- Useful life of expenditure = 10 years
- Annual return from expenditure = $70,000
- Marginal cost of Capital = 8%
Step 1:
It's formula is given as:
Formula for NPV
NPV = (Cash flows)/( 1+r)i
<em>Where</em>
i- Initial Investment
Cash flows= Cash flows in the time period
r = Discount rate
i = time period
Computing with a spreadsheet, the Net Present Value of the Investment is given at $ 19,706.
Kindly see attached spreadsheet.
Judgement: Since the NPV is positive the investment is profitable and hence Nice Ltd can go ahead with the expansion.
Cheers!
