To do this they will only need to look at the incremental cash flows, which are as follows: 1. Initial investment of $10 million that will be the cost to build the new factory. 2. Sales of $3 million a year that will result in an increase of $150,000 in gross margin giving the company a 5% gross margin. .
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Take in mind that this analysis was only for a 10-year period since this would be the expected economic life of a new factory. Moreover, on the 10th year, or at the end of the life of the asset, $14 million was included in the cash flows from the expected salvage value of the factory being sold. The present value was figured out by using the following formula PV Factor = 1/(1+r)^t r = cost of capital t = year By multiplying the cash flow column with the present value column the present value of each of the cash flows was found.
The findings show that a higher cost of capital of a firm the lower the net present value of the project will be and vice versa for lower cost of capital. Firms are more likely to reject projects that have a high cost of capital and approve projects that have a low cost of capital. The capital budgeting process is used to make decisions on capital projects such as building new factories, advertising, and buying new equipment. Capital budgeting is important for companies and is a very predominate in strategic financial management.
Capital projects are found in the non-current section of the balance sheet are usually the biggest asset section. Given the size of the non-current section making the right capital budgeting decisions will be the deciding factor of whether the company survives or not. Capital budgeting is used to make the above decisions it also can be used to make other decisions, such as the discontinuance of an operation or product and mergers and acquisitions.See More on Investment