Capital Budgeting

Capital budgeting
Acquisition investment
HP should invest in an acquisition investment with Washington Electronics Corporation. Even though PH is among the upcoming electronic and technology company, its projected annual revenues ranges within $800,000 bracket. In the course of merging and other activities, there are substantial problems that are associated with the decision. Just like any other merging activity, in order to estimate the entire cash flow required. Politics problems are among the problems that might emanate from the investment plan. There are two organization committee thus getting them understand what you are planning is quite a problem. One committee might be willing to the process of calculating cash flows and the other committee might be opposing.
The annual cost levels projected by HP for Washington Electronics Corporation is about $400,000 although it??™s a smaller company compared to HP. Incase the company succeeds to make its acquisition successful, those proposed annual costs will automatically reduce say by $100,000. If the inflation rate will act in an indefinite state, the projected growth for the entire activities such as revenues, cost incurred in the course of its merge and some cost reductions associated here and there, rate will be 10% (g=.10). Growth rate is among the key considerations that mangers look at in order to determine their businesses are growing or not. If one company has a different growth rate with the other, this tends to be tedious and difficult in amortizing the entire estimate.
In our setting, HP and the company it wants to merge with have similar corporate marginal tax rate. They operate under the 40% bracket although one is little big than the other one. Our corporate marginal income tax rate will be (c=.40). So as to have a complete merging process, shareholders of the company to be acquainted should be compensated. This is another great challenge in estimating the cash flow investments simply because compensation figures might be tempered by the committee of the organization that is being acquainted. Lets assume that $ 5,200,000 of common stock and (
To complete the merger, shareholders of the former Adams Company were compensated with $4,200,000 in Washington Company common stock and cash (P0=$4,200,000). Washington Company management determined that the appropriate discount rate for cash flows resulting from the merger was 15% (k=.15). Was Washingtons decision to merge with the Adams Company appropriate given the facts and projections that were available in 2000
The NPV technique can be used quite easily to evaluate this merger (See Table 5). Cash flows generated by this merger can be classified into two streams: the initial $4,200,000 investment and a growing perpetuity (since the purchased company has an indefinite life expectancy) reflecting the cash flows resulting from revenues, costs and corporate income taxes. The gross profits (before taxes) generated by this perpetuity in 1991 were projected to be $400,000:
($800,000 – $500,000 + $100,000) = $400,000
Because corporate income taxes must be paid on this $400,000 increase in gross profits, Washingtons taxes must increase by $160,000 (40% $400,000). Therefore, Washingtons net cash flows (after taxes) will increase by $240,000:
= $240,000 .40)- (1 $400,000
These net cash flows were projected to grow at a rate of 10% per year indefinitely. They were to be discounted at a rate of 15% in a growing perpetuity model. The value of this growing perpetuity is $4,800,000:
10 .15 .000 ,240$gp PV
Therefore, the net present value of this merger was $600,000, indicating that it was a wise investment for the Washington Corporation:
NPV = -$4,200,000 + $4,800,000 = $600,000
Rev1 = $800,000 P0 = $4,200,000 = .40
Costs1 = $500,000 k = .15
Synergies1 = $100,000 g = .10 000 ,600$) 10.15 (.] 4.1 ][000,100$000 ,500$000 ,800[$000 ,200,4$ NPV
Since NPV > 0, the merger should be consummated.
THUS, The Merger Decision