Capital Budgeting and Investment Decisions Case study Discussion

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Question Description

Capital budgeting involves evaluating investment decisions and requires managers to consider many factors to make a sound decision. These factors include an investment’s net present value (NPV), internal rate of return (IRR), and payback period. In addition, managers must weigh the risk involved in the project when calculating the weighted average cost of capital (WACC). Even with all these analytic tools, evaluating investment alternatives is complex because it relies on projections. Consider the following three scenarios. For each scenario, consider how you would proceed as a manager of this company. Be sure to include the following details to justify your thinking:

  • Do you agree with the techniques used in these scenarios? What techniques would you have used, and why?
  • Is one analytical tool “better” than another in each scenario? Why or why not?
  • What questions would you have concerning the underlying projections in each scenario?
  • How would you evaluate the risk inherent in these scenarios? How would this impact the ways in which you evaluate each scenario?

Here are the three scenarios for your consideration:

  1. You recently started a company that provides pet-sitting services for affluent customers in their homes. Based on customer feedback, you are interested in purchasing equipment that will enable customers to rent equipment to see their pets’ activities from their mobile devices. The net present value (NPV) of this project is positive with an internal return rate of 16.6%, but its payback period is 5.5 years. What do you think is important to consider in evaluating this investment opportunity?
  2. Your company is considering purchasing a robotic self-driven lawn-mowing machine to maintain its corporate office park grounds. This machine seems costly, but it will pay for itself in 2.5 years by eliminating the salaries of the maintenance employees who currently perform the lawn maintenance. Another manager points out that these employees perform not only lawn maintenance, but also a variety of other upkeep activities. You know the current maintenance staff is well-liked by the employees, who view them as hard workers. How would you frame this investment decision as a manager? What stance would you take?
  3. Due to recent government regulations, a piece of equipment will cost an estimated $250,000 to dispose of. Management projection from five years ago had figured this piece of equipment would have a $400,000 salvage value. How would knowing this information from the start have impacted your decisions? How does this new information impact the investment’s return?

Skills

  • Calculate cash flows on capital budget projects.
  • Evaluate investment opportunities using various techniques such as net present value (NPV), internal rate of return (IRR), and payback period.
  • Describe risk in capital budgeting and strategies, such as sensitivity analysis, scenario analysis, and risk adjusted discount rate.

Tutor Answer

TeacherSethGreg
School: Duke University

Attached.

Capital Budgeting
Investment Decisions
Scenario 1
The Net present value of the investment is positive with an internal rate of return of 16.6% and a
payback period of 5.5 years. Depending on the policies of the company, any factor can be
considered in evaluating the business opportunity. The net present value (NPV) of a project should
be positive so as to be accepted by the management as an investment. In this scenario, the project
has a positive NPV and should, therefore, be accepted. If the internal rate of return exceeds the
desired rate of return, the project is likely to be considered by the management. For example, if
the desired rate of return was 12% the project will be considered beca...

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