Capital budgeting


Capital budgeting is the process of evaluating potential long-term investments available to a firm. It involves large initial expenditures, which hopefully increase firm profitability, producing incremental cash inflows for the firm in the future. Some examples of capital budgeting include: the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing new buildings, renovating existing buildings, joint ventures, expanding into new markets, introducing new products to existing markets, cost-saving technologies, research and development, and similar activities.

The process of capital budgeting involves:

  • Identifying a potential investment project.
  • Estimating all incremental cash flows (both outflows and inflows) of the project.
  • Evaluating the projected future incremental cash flows using present value techniques.
  • Deciding whether to accept or reject the project.
  • If the project is accepted, implementing the project and then periodically comparing actual cash flows to projected cash flows as a means of continual improvement in the capital budgeting process.

Effectively identifying and implementing positive value projects is essential for a company to grow. In fact, in a world where most firms grow annually, any firm that does not engage in successful capital budgeting will fall behind and eventually go bankrupt. However, firms that do poor capital budgeting can also go bankrupt for accepting projects, which should have been rejected and rejecting projects, which should have been accepted. Proper capital budgeting decisions are important to shareholders because the positive present value of a project directly translates into increased shareholder wealth. Thus, capital budgeting is the most effective way for financial managers to achieve the goal of financial management that you learned about in the first week of this course.

Part I: One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and must be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects are needed. This procedure is called capital budgeting.

Virtually all general managers face capital-budgeting decisions in the course of their careers. The most common of these is the simple yes versus no choice about a capital investment. Regardless of the type of project, however, certain principles of capital budgeting should always be considered. The most important of these principles are: • Focus on cash flows, not profits.

  • Focus on incremental cash flows.
  • Account for time.
  • Account for risk.

Now, write an essay discussing the meaning and importance of each of these principles as they apply to capital budgeting. Evaluate the importance of each principle and discuss the consequences of ignoring any of these principles.

You must use a minimum of three scholarly sources to support your discussion.

Part II:

A private school is considering the purchase of six school buses to transport students to and from school events. The initial cost of the buses is $600,000. The life of each bus is estimated to be 5 years, after which time the vehicles would have to be scrapped with no salvage value. The school’s management team has derived the following estimates for annual revenues and cost for the next 5 years.

Year 1Year 2Year 3Year 4Year 5
Driver costs$33,000$35,000$36,000$38,000$40,000
Repairs and maintenance$8,000$13,000$15,000$16,000$18,000
Other costs$130,000$135,000$140,000$136,000$142,000
Annual depreciation$120,000$120,000$120,000$120,000$120,000

The buses would be purchased at the beginning of the project (i.e., in Year 0) and all revenues and expenditures shown in the table above would be incurred at the end of each relevant year.

Because schools are exempt from taxes, the school’s corporate tax rate is 0 percent. A business consultant has advised management that they should use a weighted average cost of capital (WACC) of 10.5% to evaluate this project.

  • Prepare a table showing the estimated net cash flows for each year of the project. Explain all steps involved in your calculation of the Year 1 estimated net cash flow.
  • Calculate the project’s Payback Period. Explain in your own words, all steps involved in the calculation process.
  • Calculate the project’s Internal Rate of Return (IRR). Explain in your own words, all steps involved in the calculation process.
  • Calculate the project’s Net Present Value (NPV).
  • Explain in your own words, all steps involved in the calculation process.
  • Which of the three evaluation techniques that you computed (i.e., payback period, IRR and NPV), should the firm use to make its decision of whether or not to accept this project? Why did you choose this technique? Is one of these techniques better than the others and if so, why?

Finally, what are some risk factors inherent in this capital budgeting analysis? Make a list of at least three items that could cause the outcome of this project to be substantially worse than management currently expects (as reflected in their revenue and cost estimates, WACC estimate, etc.). Fully explain each of the risk factors you identify. Length: 4-5 pages, not including title page and references; (You may wish to include an appendix to accommodate tables and figures.) References: You are expected to provide at least three references for this assignment. Your paper should demonstrate thoughtful consideration of the ideas and concepts presented in the course and provide new thoughts and insights relating directly to this topic.

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