ABC Ltd is considering adding a new product line. Adding the product line would require additional investment of £0.5 million today and would return cash flow of £0.6 million in one years time.ABCs assets consist of £0.5 million in cash, as well as production facilities to produce its existing products. Next year these facilities will return cash flows of £5 million if the demand is high and £2 million if the demand is low. The probability of high demand is 70%. The firms discount rate is 0% and you can ignore all cash flows extending beyond one year. Assume that ABC has no debt. (a) What is the expected net worth of ABCs owners if they do not add the new product line and instead pay the cash out as dividends? ( b) What is the expected net worth of ABCs owners if they choose to add the new product line instead of paying out dividends? (c) Now redo assuming the company has debt with face value $2.5 million due in one year. What is the expected net worth of ABCs owners if they do not add the new product line but rather pay the dividend? (d) Continue to assume that the company has debt of $2.5 million due in one year. What is the expected net worth of ABCs owners if they choose to add the new product line and not pay the dividend? (e) Do your answers in parts (a) to (d) show that the value of the company is not optimized when the firm has debt? Use figures to support your conclusions. Use the table format to present your answers.
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
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