CAPITAL BUDGETING

Capital Budgeting

Capital Budgeting

Question 1

Straight Line Depreciation of the Plant and Machinery :

=purchase price - approximate salvage value ÷ years estimated useful life

=(4,250,000 - 425000 )/5

= 765000

Payback Period = A + ( B / C ) where

A = Years before final payback year

B = Total to be paid back - Total paid back at start of final payback year

C = Total paid back in the entire payback year

According to this the Whole amount of the machinery that is £5, 000,000 will be paid back in the year 2011.

NPV

NPV>0, it means that the investment would add value to the firm and therefore it should be accepted.

IRR

The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR). In the context of savings and loans the IRR is also called the effective interest rate. The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation).

(See Attached Excel Sheet For calculations)

Question 2

Decision-making is increasingly more complex today because of uncertainty. Additionally, most capital projects will involve numerous variables and possible outcomes. For example, estimating cash flows associated with a project involves working capital requirements, project risk, tax considerations, expected rates of inflation, and disposal values. We have to understand existing markets to forecast project revenues, assess competitive impacts of the project, and determine the life cycle of the project. If our capital project involves production, we have to understand operating costs, additional overheads, capacity utilization, and startup costs. Consequently, we can not manage capital projects by simply looking at the numbers; i.e. discounted cash flows. We must look at the entire decision and assess all relevant variables and outcomes within an analytical hierarchy.  Unlike accounting, financial management is concerned with the values of assets today; i.e. present values. Since capital projects provide benefits into the future and since we want to determine the present value of the project, we will discount the future cash flows of a project to the present. Discounting refers to taking a future amount and finding its value today. Future values differ from present values because of the time value of money. Financial management recognizes the time value of money because: 

1. Inflation reduces values over time; i.e. $ 1,000 today will have less value five years from now due to rising prices (inflation). 

2. Uncertainty in the future; i.e. we think we will receive $ 1,000 five years from now, but a lot can happen over the next five years. 

3. Opportunity Costs of money; $ 1,000 today is worth more to us than $ 1,000 five years from now because we can invest $ 1,000 today and earn a return. Present values are calculated by referring to tables or we can use calculators and spreadsheets for discounting. The discount rate we will use is the opportunity costs of the investment; i.e. the rate of return we require on any other project with similar risks. 

Question 3

A

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