Financial Management (Capital Budgeting Mini Case)

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FINANCIAL MANAGEMENT: CAPITAL BUDGETING MINI CASE

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CAPITAL BUDGETING (MINI CASE)

QUESTION A What is capital budgeting?

Solution: Capital budgeting is a required managerial tool. 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. In other words, capital budgeting is the process of analysing additions to fixed assets. Capital budgeting is important because, more than anything else, fixed asset investment decisions chart a company's course for the future. Conceptually, the capital budgeting process is identical to the decision process used by individuals making investment decisions. These steps are involved:

1. Estimate the cash flows--interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects. 2. Assess the riskiness of the cash flows. 3. Determine the appropriate discount rate, based on the riskiness of the cash flows and the general level of interest rates. This is called the project cost of capital in capital budgeting. 4. Evaluate the cash flows.

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QUESTION B What is the difference between independent and mutually exclusive projects? Solution: Projects are independent if the cash flows of one are not affected by the acceptance of the other. Conversely, two projects are mutually exclusive if acceptance of one impacts

adversely the cash flows of the other; that is, at most one of two or more such projects may be accepted. Put another way, when projects are mutually exclusive it means that they do the same job. For example, a forklift truck versus a conveyor system to move materials, or a bridge versus a ferry boat. How is a mutually exclusive or an independent project chosen? The most important thing that a business owner absolutely must do is compare the rate of return that the project will earn to the weighted average cost of capital or what the company pays to obtain financing. The decision rule is the; if the rate of return is greater than the weighted average cost of capital, then accept and invest in the project. If the rate of return of the project is less than the weighted average cost of capital, then rejects and does not invest in the project. This rate of return is actually an opportunity cost. In other words, the rate of return is the cost of investing in one project as opposed to another. Projects with normal cash flows have outflows, or costs, in the first year (or years) followed by a series of inflows. Projects with non-normal cash flows have one or more outflows after the inflow stream has begun. Here are some examples:

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

Non-normal

+

+ + +

+ + +

+ -

+ + -

-

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QUESTION C 1. What is the payback period? Find the paybacks for Franchises L and S. Solution: The length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions. Calculated as: Cost of Project = _______________ Annual Cash Inflows Franchise L 0 | -100 1 | 10 -90 2 | 60 -30 3 | 80 50

Franchise S 0 | -100 1 | 70 -30 2 | 50 20 3 | 20 40

Franchise L's $100 investment has not been recovered at the end of year 2, but it has been more than recovered by the end of year 3. Thus, the recovery period is between 2 and 3 years. If we assume that the cash flows occur evenly over the year,...
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