Capital Budgeting

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Question a
What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? Capital budgeting is the process of analyzing potential additions to fixed assets. Capital budgeting is very important to firm’s future because of the fixed asset investment decisions chart a company’s course for the future. The firm’s capital budgeting process is very much same as those of individual’s investment decisions. There are some steps involved. First, estimate the cash flows such as interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects. Second is to assess the riskiness of the cash flows. Next, determine the appropriate discount rate, based on the riskiness of the cash flows and the general level of interest rates. This is called project’s required rate of return or cost of capital in capital budgeting. Then, find the PV of expected cash flows and the asset’s rate of return. If the PV of the inflows is greater than PV of outflows (NPV is positive), or if the calculated rate of return (IRR) is higher than the project cost of capital, accept the project.

Question b
What is the difference between independent and mutually exclusive projects? Between normal and non-normal projects? Independent projects mean a company can select one or both of the projects as long as they meet minimum profitability. This is because the projects do not compete with the firm’s resources. Projects are independent if the cash flows of one are not affected by the acceptance of the other. Mutually exclusive projects mean if acceptance of one impacts adversely the cash flows of the other which is firm can select one or another project but not both. This is because projects investments that compete in some way for a company’s resources. When projects are mutually exclusive it means that they do the same job. Normal projects have outflows, or costs, in the first year (or years) followed by a series of inflows. Non-normal projects have one or more outflows after the inflow stream has begun.

Inflow (+) Or Outflow (-) In Year
0 1 2 3 4 5
Normal - + + + + +
- - + + + +
- - - + + +

Non-normal - + + + + -
- + + - + -
+ + + - - -

Question c
1) Define the term net present value (NPV). What is each project’s NPV? Net present value (NPV) is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. By using financial calculator, the NPV for project L is RM 18,782.87 while the NPV for project S is RM 19,984.97.

2) What is the rationale behind the NPV method? According to NPV, which project or projects should be accepted if they are independent? Mutually exclusive? The rationales behind the NPV method are; if the NPV is more than zero, the project will be accepted, but the project would be rejected if the NPV is less than zero. The NPV that equal to zero means it is technically indifference whether we accept or not the project, will not gain any benefit or loss.

According to NPV, both projects can be accepted if they are independent because the NPV for both project have positive value of more than zero. But, if they are mutually exclusive, only one project that should be accepted that is project S. This is because the NPV for project S is more higher compared to the NPV for project L.

3) Would the NPVs change if the WACC changed?...
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