Capital Budgeting

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  • Topic: Net present value, Internal rate of return, Cash flow
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  • Published : May 12, 2011
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Capital Budgeting

Luz A comas

Strayer University

Professor: Michael Hamuicka

Financial Management – FIN 534



Capital budgeting is one of the most important areas of financial management. There are several techniques commonly used to evaluate capital budgeting projects namely the payback period, accounting rate of return, present value and internal rate of return and profitability index. Recent studies highlight that financial managers worldwide favor methods such as the internal rate of return (IRR) or non-discounted payback period (PP) models over the net present value (NPV), which is the model academics consider superior.

The term capital budgeting refers to long term planning for proposal capital outlay and their financing. It includes rising long-term funds and their utilization. It may be defined as firms, formal process of acquisition and investment of capital. Capital Budgeting may also be defined as the decision making process which the firm evaluates the purchase of major fixed assets. It involves firm’s decision to invest its current funds for addition, disposition, modification and replacement of fixed assets. 

In particular this assignment focused on Bauer Industries. Bauer Industries is an automobile manufacturer. Management is evaluating a proposal to build a plant that will manufacture lightweight trucks. An important responsibility of corporate financial managers is determining which projects or investments a firm should undertake. The assignment shows the mathematical solutions for the problem.

Capital Budgeting
1. Bauer Industries is an automobile manufacturer. Management is currently evaluating a proposal to build a plant that will manufacture lightweight trucks. Bauer plans to use a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental free cash flow projections (in millions of dollars):

Year 0 years 1-9 year 10

Revenues 100.0 100.0
* Manufacturing expenses
(Other than depreciation) -35.0 -35.0
* Marketing expenses -10.0 -10.0 * Depreciation -15.0 -15.0

= EBIT 40.0 40.0 * Taxes (35%) -14.0 -14.0

Year 0 Years 1-9 Year 10 = Unlevered net income 26.0 26.0 + Depreciation +15.0 +15.0 - Increases in net working capital - 5.0 - 5.0 -Capital expenditures - 150

+ Continuation value +12.0 = Free cash flow - 150 36.0 48.0

a. For this base-case scenario, what is the NPV of the plant to manufacture lightweight truck? b. Based on input from the marketing department, Bauer is uncertain about its revenue forecast. In particular, management would like to examine the sensitivity of the NPV to the revenue assumptions. What is the NPV of this project if revenues are 10% higher than forecast? What is the NPV if revenues are 10% lower than forecast? c. Rather than assuming that cash flows for this project are constant, management would like to explore the...
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