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 be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is 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.
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 3 scholarly sources to support your discussion.
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 five 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 five years.
|Year 1||Year 2||Year 3||Year 4||Year 5|
|Repairs & maintenance||$8,000||$13,000||$15,000||$16,000||$18,000|
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 percent 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 is 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? 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? That is, 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 pages not including title page and references
Your response should demonstrate thoughtful consideration of the ideas and concepts presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards.
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Explanation & Answer
Running Head: CAPITAL BUDGETING PROCEDURES
CAPITAL BUDGETING PROCEDURES
Part 1-Principles of capital budgeting
Capital budgeting operates with principles. Such principles include a focus on cash flows,
not profits; focus on the incremental cash flows, accounting for a time as well as risk (Bierman &
Smidt, 2012). Such principles help finance managers to establish whether a project is worth.
Cash flows help an organization to take advantage of any emerging opportunities that may yield
returns for the company. A company may be profitable but lacks adequate cash flows
constraining or frustrating other activities that may help in smooth running of the organization
(Bierman & Smidt, 2012). If a new project is initiated, the principles of capital budgeting assume
that there are estimated incremental cash flows that may arise from the project. Also, finance
managers should at the time as well as risks involved in establishing a new project. The time
value of money is essential in capital budgeting decisions. Money in the present moment is
preferred than money in the distant future. For instance, the more the time it takes to recover
costs the riskier it gets due to uncertainty in the future money (Ross, Westerfield & Jaffe,2002).
Importance of the capital budgeting principles cannot be overemphasized (Bierman &
Smidt, 2012). For example, cash flows must be stable for an organization to run. Otherwise, it
may be impossible to run the company projects. Also, any project initiated must have
incremental cash flows for a project to be worthwhile. On the time issue, projects must have a
definite lifespan over which the stakeholders may get returns (Bierman & Smidt, 2012). Also, it
should not take very long before benefits in cash inflow is realized otherwise the project may
cause cash problems. Companies should also implement projects whose risks it can absorb. To...