Incremental Cash Flows
Once a firm has compiled a list of prospective investments, it must then select from among them that combination of projects that maximizes the firm’s value to its shareholders. This selection requires a set of rules and decision criteria that enable managers to determine, given an investment opportunity, whether to accept or reject it. The criteria of net present value are generally accepted as being the most appropriate one to use because its consistent application will lease the company to select the same investments the shareholders would make themselves if they had the opportunity. Inflation and fluctuating currency rates have always made it unwise to just deposit money in the bank for a long time. However, it requires making the right business decisions before the capital value could be preserved (Edelman, 2005).
Financial analysis tools are quite important for estimating the improvement in the value of capital of a company over time. For instance, Net Present Value (NPV) is used to evaluate the cash inflows and outflows of an investment and it is useful in determining the profitability of an investment (Brigham and Houston, 2007). Similarly, the Internal Rate of Return is another instrument, which investors use to determine if the viability of the project. It shows whether the project will break even (Groppelli & Nikbakht, 2000; Gitman, 2009). Both NPV and IRR are useful to investors as they help them make distinct decisions on whether to go into a business venture or not. The cash flows of the investment are as flows;
|Details||2010||Year 2011-2020||Year 2020|
|Increase inventory of parts||(30,000)|
|Cost of tags||(80,000)|
|Taxation( 30%) / tax saving||15,000||39,000|
|After tax cash flows||(1,535,000)||(91,000)|
|Depreciation tax shield- equipment||30,000|
|Depreciation tax shield- radio receiver||15,000|
Note 1: Allocated overhead will not be considered in this case as they will be incurred whether the project is undertaken or not.
Note 2: equipment tax shield = 30% of 1,000,000/10 = 30,000
Note 3: radio receiver tax shield = 30% of 500,000/10 = 15,000
Note 5: Interest tax shield = 30% of 4,000 = 1,200
To find out the viability of the project net present value will be used.
Net present value =
Where Ct is the cash flows from year 1 to year N- Which is (44,800)
K is the cost of capital- which is 14%
Co is initial investment- which is
N is the expected life of the investment- which is
From the calculations shown below the net present value for this project is obtained
NPV= (-44,800xPVIF10yrs14%) – 1,535,000
NPV= (-44,800×5.2161) – 1,535,000
According to these criteria the project has a negative net present value therefore it is rejected.
Effects of High Tax Rate on Project Viability
The project viability is affected by the tax rate applicable. This is because a high tax rate reduces the net cash flow of the project through taxation. In evaluating a project, tax is applied to net cash flows therefore as the tax rate increases, the net cash flows decrease. As pointed out, the tax savings associated with the use of debt are not certain. If reported income is consistently low or negative, the tax shield on debt is reduced or even eliminated.
As a result, the near-full or full cash-flow burden of interest payments would be felt by the firm. If the firm should go bankrupt and liquidate, the potential future tax savings associated with debt would stop altogether. We must recognize also that Congress can change the corporate tax rate. Finally, the greater the possibility of going out of business, the greater the probability the tax shield will not be effectively utilized. These entire things make the tax shield associated with debt financing less than certain (Brigham and Houston, 2007; Edelman, 2005).
The uncertain nature of the interest tax shield, together with the possibility of at leases some tax shelter redundancy. As leverage increases, the uncertainty associated with the interest tax occurs, tax shield uncertainty causes a value to increase at an ever-decreasing rate and perhaps eventually to run down (Helfert, 2001; Ryan and Ryan, 2002). Thus, the more uncertain the corporate tax shield the less attractive debt becomes. The value of the firm now can be expressed as
Value of = Value if + Pure value of corporate – Value lost through tax
Firm unlevered tax shield shield uncertainty
The last two factors combined give the present value of the corporate tax shield. The greater the uncertainty associated with the shield, the less important it becomes.
The statement is true. The shift of the companies to countries with low tax rates because high taxes disincentives investments and this lessens the country’s competitiveness. Low tax rates allow the country to attract capital and gain more productivity. What it wishes to stress is that taxes will significantly affect the economy because these provide the government with funds to maintain and promote economic activities. The issue of tax reform, however, is another concern best addressed in other research endeavours (Bragg, 2006; Pandey, 2009).
Importance of credit rating for bond of companies
To begin with, investors are looking for investments that are reliable and can offer a return for money invested. The bond investment provides this although they are tricky investments; therefore, investors are keen before involving themselves. A new investment by an investor in bonds depends on many factors, which include; investment time frames and goals, one’s tax status, and the amount of risk the investor is willing to take. On the same note, the investor must understand the importance of diversification when going for a bond investment strategy.
This investment involves an investor giving his/her money to an institution with the expectation of getting the money back plus interest. In many cases, business firms, private institutions, and governments issue bonds to investors with the aim of expanding business or funding public programs and projects respectively ( Rao, 1989).
Therefore, bond ratings provide investors with reliable, professional evaluations of issues at a reasonable cost. This information is indispensable for assessing the economic value of a bond. Investors investing in bonds also find published bond ratings useful. Individual investors generally do not have the ability to diversify as extensively as do large institutions. With limited diversification opportunities, an individual should invest only in bond with higher credit ratings. A bond rating is intended to be a comparative indicator of overall credit quality for a particular bond issue. However, the rating in itself is not a recommendation to buy or sell a bond. Without a credit rating, a new bond issue would be very difficult to sell to the public, which is why almost all bond issues originally sold to the general public have a credit rating assigned at the time of issuance.
Interest rate of the loan 8.5% and loan amount is €1.1billion. If they issue €1billion bond, then
Current annual interest is 8.5% of € 1.1billion = € 93.5 million
New interest will be calculated as follows;
New interest rate for the bond will 7.0%+1%= 8%
Bond interest will be 8% of € 1billion = € 80million
Interest for remaining amount of loan (1.1-1) billion 8.5% = € 8.5million
Therefore interest saving will be € 93.5 million-€ 88.5million = € 5 million
Yield to maturity is
Current yield = interest = (1.08/2%) 2 x 100 = 8.33%
Investment (0.98/1) x100%
Interest rate for the bond 8.33%
The decision will not change because the yield to rate is less than rate offered by the bank.
This bond will be attractive because it has a lower interest rate thus less risk. The US-dollar bond will not also be affected by exchange rate as the Eurobond. At times foreign markets do worse than domestic markets.
The potential risk of following this advice is that it will only attract investors in the USA market. Nevertheless, investors have some options in which interest rate risk can be controlled. They include buying interest rates derivatives. A derivative is a form of security, whose value depends on the value of another asset. Moreover, investors can decide to invest in floating rate securities, instead of investing in fixed-rate securities.
Similarly, an investor should only invest in securities that are due to mature in the short term. Such an investor will be assured of interest payments, which occur twice a year. Eventually, the investor will receive the face value of his/her bond upon maturity. First of all, it will help them to speculate the interest rates. It is particularly common to find investors who anticipate falls in market interest rates. These declines can transpire from stimulant rate cuts by the Federal Reserves. Under such circumstances, an investor would attempt to augment the standard duration of their bond portfolio.
The expenses have been cut although they may be reduced further. This could however pose a risk to the fund due to tax inefficiency and persistent costly brokerage commissions. Failure of merger can lead to shrinkage of returns. Also the world mergers and acquisition worldwide has increased in complexity. The fund has also had low volatility; low connection with the market and hence a good portfolio diversifier (Brealey, Myers and Marcus, 2007).
The team managing the fund has a tendency of avoiding high risks. Arbitrage of merger is a strategy that ensures low volatility. It is a strategy that is designed to deliver good returns irrespective of overall quality or the fixed income market performance. It helps to reduce the risks since it is a low volatility bet. However this fund is not suitable for long-term investment purposes. For long term purposes it becomes as risk as fixed income investments (Peirson, Brown, Easton, Howard and Pinder, 2000).
Maturity and yield-curve are important in equivocating positions, where the assortment of bonds is hedged with bonds of dissimilar interest rates and maturities. These bonds are implicit to transform under changes in prevailing rates. Yield-curve risks occur when prices of bonds with different maturities swerve from this postulation when existing rates change (Pandey, 2009).
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Ryan, P, & Ryan, G., 2002. Capital budgeting practices of the Fortune 1000: How have things changed? Journal of Business and Management, 8 (4), pp. 355-364.