What is capital budgeting?
Capital budgeting is the process where process where businesses determine whether projects such as investing in a long-term endeavor or building a new plant is worth investing or pursuing. The prospective lifetime cash outflow and inflow are analyzed in order to determine whether returns generate and meet a targeted mark.
Why are capital budgeting decisions crucial to the long-run financial health of a business enterprise?
Delegate your assignment to our experts and they will do the rest.
Capital budgeting decisions are crucial because it involves substantial expenditure, is a long-term investment, are irreversible, and are complex decisions involving future events. Capital budgeting decisions usually involve investment of huge amount of funds. It is thus important for a company to make decisions after careful consideration as resources could be scarce. Capital budgeting is carried out over a long period and can affect future benefits. Most decisions are irreversible due to the difficulty to find a buyer for second-hand capital items. The decisions are complex as it involves the future that can be difficult to predict.
Exercise 26.1
Incremental analysis
Sunk cost
Capital budgeting
Return on average investment
Payback period
None, the statement describes the amount that should be subtracted from the initial cost of an asset when determining the net present value
Present value
Discount rate
Salvage value
Exercise 26.2, page 1132
Heartland Paper Company.
Payback Period = Amount to be invested / Estimated Annual Net cash
But estimated Annual net cash inflow = Cash inflow – Cash outflow
Estimated Annual Net cash = $26,000 - $20,000 = $6,000/year
Payback period = $27,000 / $6,000/year
Payback period = 4.5 years
Cost if the payback period is 66 months
Cost = Payback period * Estimated Annual Net cash
Cost = 66 months/12 * $6,000
Cost = $33,000
Based on the calculation of the recovery periods, the Toledo Tools has a lesser recovery period than that of the Akron Industries by 1 year. The Toledo Tools machine is thus preferred. However, the payback period is not the only factor that can be used to evaluate an investment decision. Other factors such as time value of money and profitability should also be considered when considering budgeting decisions.
Exercise 26.4
Using the tables in Exhibits 26-3 and 26-4.
Present value of $10,000 to be received 20 years from today.
Present value = Cash flow * Present value of $1 due in 20 years
Present value = $10,000 * 0.061
Present value = $ 610
Present value of $15,000 to be received annually for 10 years.
Present value = Cash flow * Present value of $1 to be received periodically for 10 years
Present value = $ 15,000 * 5.019
Present value = $75,285
$10,000 to be received annual for five years with an additional $12,000 salvage value expected at the end of the fifth year.
| Annual cash flow for 5 years [a] | $10,000 |
| Present value of $1 to be received periodically for 5 years [b] | 3.352 |
| Present value of annual cash flows [c = a *b] | $33,520 |
| Expected Salvage value at the end of the 5 th year [d] | $12,000 |
| Present value of $1 due in 5 years [e] | 0.497 |
| Present value of salvage value [f = d*e] | $ 5,964 |
| Total present value of cash flows [c + f] | $39,484 |
$30,000 to be received annually for three years followed by $20,000 annually for the next two years.
| Annual cash flow for 3 years [a] | $30,000 |
| Present value of $1 to be received periodically for 5 years [b] | 2.283 |
| Present value of annual cash flows [c = a *b] | $68,490 |
| Annual cash flow for the next 2 years [d] | $20,000 |
| Present value of $1 due in 4 th year [e] | 0.572 |
| Present value of $1 due in 5 th year [f] | 0.497 |
| Present value of $1 due in 4 th year and 5 th year [g = e + f] | $ 1.069 |
| Present value of cash flows in 4 year and 5 years [h = d * g] | $21,380 |
| Total present value of cash flows [c + h] | $89,870 |
Problem 26.2A, page 1136
Micro Technology.
(1) Payback period calculation
Payback period of proposal 1 = Required Investment / Estimated Annual Net Cash Flows
Payback period of proposal 1 = $360,000 / $75,000
Payback period of proposal 1 = 4.8 years
Payback period of proposal 2 = Required Investment / Estimated Annual Net Cash Flows
Payback period of proposal 2 = $350,000 / $76,000
Payback period of proposal 2 = 4.6 years
(2) Return on average investment
Proposal 1:
Average Investment = (Original Cost + Salvage value) / 2 = ($360,000 + $0) / 2 = $180,000
Average Estimated Net Income = Total Net Income/Period of Income Generation = $30,000
Average Return on Investment = Average Estimated Net Income / Average Investment
Average Return on Investment = $30,000 / $180,00 * 100 = 16.70%
Proposal 2:
Average Investment = (Original Cost + Salvage value) / 2 = ($350,000 + $14,000) / 2 = $182,000
Average Estimated Net Income = Total Net Income/Period of Income Generation = $28,000
Average Return on Investment = Average Estimated Net Income / Average Investment
Average Return on Investment = $28,000 / $182,00 * 100 = 15.40%
(3) Net present value
Proposal 1
| Particulars | Amount ($) | Discounting factors | P.V of Amounts ($) |
|
Estimated annual cash flows discounted at 12% for 8 years Total present value of future cash flows Les: Amount to be invested (payable in advance) |
75,000 (360,00) |
4.968 | 372,600 |
| 372,600 (360,000) | |||
| Net Present Value of the Proposed Investment | 12,600 |
Proposal 2
| Particulars | Amount ($) | Discounting factors | P.V of Amounts ($) |
|
Estimated salvage value at the end of the 7 th year Estimated annual cash flows discounted at 12% for 7 years Total present value of future cash flows Les: Amount to be invested (payable in advance) |
14,000 75,000 (350,00)) |
0.452 4.564 |
6,328 346,864 |
| 353,192 (360,000) | |||
| Net Present Value of the Proposed Investment | 3,192 |
The net present value is the most appropriate method for selecting an investment because it considers several factors such as the time value of money, the timing of future cash flows, and associated risk with future cash flows. The payback and return on investment should not be used as the only factors for an investment decision as it ignores timing of the future cash flows and the cash flows anticipated in the entire life of the project. From the above analysis, proposal 1 should be chosen because it gives a higher net present value and higher percentage of return than proposal 2.
