Capital Expenditure Analysis Research Paper Example | Topics and Well Written Essays - 1000 words

Capital Expenditure Analysis - Research Paper Example Is this a good investment There are four calculations one could use to answer this question: (1) payback, (2) discounted cash flow, (3) internal rate of return, and (4) opportunity cost. But before one could make these calculations, two other sets of information are needed. First, the alternative financing schemes for the project are identified: (1) all equity, (2) all-debt, or (3) a combination of debt and equity. Second, the following variables need to be determined: (1) discount rate, (2) inflation rate, (3) risk-free rate of return, and (4) loan rate. An important set of assumptions can also be made: taxes, depreciation, and the costs of improvements and operations would be disregarded in this first stage of evaluating the alternatives. An all-equity purchase means the property will be paid for in cash from personal savings or investments. In this option, the buyer withdraws $360,000 from savings or puts together one or more investors (friends or relatives) to pay the property owner this amount. An all-debt purchase means borrowing the full amount of $360,000 from the bank at a certain loan interest rate. One problem is finding a bank willing to lend the full amount of the property, not impossible given the way property prices are rising, but neither easy. The other is getting a loan maturity of five years or more to coincide with the sale date for the property. The mixed option combines savings/investments and a loan. The buyer can combine $100,000 of his money with $100,000 from a friend and borrow $160,000 from the bank. Deciding the right equity-debt mix is tricky depending on the loan rate and whether the rate is fixed or adjustable (usually annually), because rising rates would affect the cash flow. Variables There are four variables to be inputted into the formulas for the investment analysis. The (1) discount rate, which reflects the time value of money, is needed for discounted cash flow calculations. The (2) risk-free and (3) inflation rates are needed for opportunity cost calculations. We also need the risk-free rate and the (4) loan rate for the discounted cash flow and internal rate of return analysis as these affect the cash flow. The risk-free rate is the rate of return of a risk-free investment such as a Treasury Note or Bond, and acts as the benchmark for banks and businessmen in determining whether a project is worth the risk of the investment. If a risky investment gives the same return as the risk-free rate, it would not be attractive as an investor would expect to be compensated for higher investment risk. Looking at the updated statistics in the latest issue of The Economist (2007: 105), the risk-free rate, using the return for five-year Treasury Notes, ranges from 4.9% to 6.4%. The inflation rate is important because it "eats up" the value of money. If an investment gives only a return equal to the risk-free rate, the investor ends up losing money due to inflation. Therefore, the inflation rate has to be included in calculating the discount rate to ensure that the calculations take inflation into account. The table shows inflation ranging from 2.4% to 2.7%. The loan rate is the annual interest a bank charges from borrowers and may differ for each bank depending on several factors that are complex to enumerate. However, the loan rate is normally close to or between the discount and risk-free rates because loans are risky for banks (so they expect higher returns) but should not be too high to discourage borrowing. Since banks get their funds from depositors willing to accept