Evaluate a Capital Budgeting Case Study
Focus on Cash Flows, not Profits
It is expected that all capital investments should earn a return that can be evaluated by comparing the projected cash outflows of the project to its cash inflows. Different methods can be used to determine the earnings of the project, for example, the profitability index, NPV, and accounting return rate. Such methods determine the cash outlays and inflows from capital investment. Using data based on cash helps evaluate a project to provide a measure to delineate the costs and benefits of capital projects that are verifiable. The information can then be used to select and prioritize projects based on the expected returns. When cash inflows and outflows are identified, they can be used to make an impact on a capital investment apparent to the investors and any interested parties. Cash flows in capital budgeting help in different types of spending, such as renovation spending and physical assets outlay (Nordmeyer, 2014). Cash flows help determine whether the project goals are realizable and realistic given the allocated resources. An organization may seem to make significant profits but is short on cash flows for its obligations. In such cases, net profits are merely numbers, yet a project is not profitable in the real sense.
Focus on Incremental Cash Flows
Increment cash flows are used to review the changes in the cash inflows and outflows that are attributed specifically because of the management’s decision. For instance, if an organization wants to modify the machine production capacity, the decision about such a process should be made based on the incremental cash flow needed to modify the equipment capacity. Additionally, the incremental cash flow that results from that decision needs to be considered. It is needless to consider all the cash flows associated with the machine’s operation.
Account for time
Investing in a project, such as expanding a business or acquiring other businesses, may take some time before the project starts earning profit to the project’s desirable cash flow. A business organization must ascertain whether the cash flows are worth the investment to be made (Merritt, 2015). For this reason, accounting for time is very important in capital budgeting. The time value for money and accounting for time is a concept that determines if the cash in hand is more than that amount in future.
Account for risk
Due to the volatile nature of the global economy, investors are searching for safer investment alternatives. Investors utilize capital budgeting to select where to invest. In a capital budget, various risks may be associated with the investment. Such risks include the collapse of the investee company, late payment of cash flows or sinking of the invested funds in risky projects by the management. Incorporating risks during capital budgeting will enable investors to minimize losses (Adams, 2012). Every investor wants to avoid risks. To encourage them to put their money into risky projects, the returns from these projects must be significantly higher than those of less risky investments, such as treasury bonds.
Adams, D. (2012). The Best Ways to Incorporate Risk Into Capital Budgeting. Retrieved from http://smallbusiness.chron.com/ways-incorporate-risk-capital-budgeting-15317.html
Merritt. C. (2015). Why Is the Time Value of Money So Important in Capital Budgeting Decisions. Retrieved from http://smallbusiness.chron.com/time-value-money-important-capital-budgeting-decisions-61898.html
Nordmeyer, B. (2014). Reasons For Using Cash Flow in Capital Budgeting. Retrieve from http://smallbusiness.chron.com/reasons-using-cash-flow-capital-budgeting-34418.html
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Week 7 – Assignment: Evaluate a Capital Budgeting Case Study
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.
|Repairs & maintenance
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: 4-5 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.