1.1
Capital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. Capital budgeting relates to the investment in assets of an organization that is relatively large. That is, a new asset or project will amount in value to a significant proportion of the total assets of the organization. Capital expenditures may at times not involve non-current assets, for instance expenditure can be used on a service like advertising, promotion or in information management.
1.2
The Key motive for capital expenditure include expansion, replacement, renewal and/or investment in non-tangible assets like research and advertising. . Where a firm has assets and a long term objective to grow, CAPEX can assist in acquiring of assets and strengthening the balance sheet. Acquiring assets for expansion is not always the route to expansion as other factors like efficiency, and policy framework can hinder the expansion. In some cases, replacement can add value especially where newer assets yield better e.g in a production line. For some reasons, capital expenditure may just be for renewal, e.g a project that is on expiry stage can be injected with capital to renew it
1.3
Capital Budgeting has several stages and their outline relies on the author. The stages can be summarized into five and the five stages are outlined below.
a) Generation of investment proposals
This step involves identifying projects consist with the firm’s business strategy and conducting a preliminary evaluation and screening of these proposals. The sources for the investement proposals can be employees, competitors, board, customers and/or statutory requirements.
Proposals that are shortlisted and survive the first screening undergo further refinement. In this stage additional data is gathered for several diverse sources. The data is needed to estimate a project’s inflows and outflows. The data can be sourced from the departments of logistics, accounting, engineering and al finance depending on a firm’s structure. In most cases this is relatively the most difficult stage of capital budgeting.
c) Evaluation of expected cash flows
This step involves determining the financial viability of projects. Both quantitative and qualitative methods are used to evaluate projects according to specified selection criteria. For instance, a project can be checked if it complies with statutory requirement, e.g environmental policy adherence. In quantitative, measures like NPV, IRR, MIRR can be used to evaluate the expected cash flows.
d) Selection and Implementation of proposals
This step concerns selecting the projects that make up the final capital budget. The project selected is one that satisfies the requirements and is the most desirable basing on stage 4 evaluations. Final budgeting approval and authorization is done at this stage. Implementation involves initiating and tracking projects. In implementing the project continual tracking is done to avoid problems.
e) Continual reevaluation of proposals
During the course of the project tacking is done to compare the estimated costs to the actual costs as a way of identifying variances such as cost overruns. Such monitoring helps to avoid delays and enables the firm to make appropriate decisions if problems arise during the course of the project.
At the end of the project , terminal evaluation is done at the end of a project where post completion audits are carried out. The audits assist in identifying errors or biases in the capital budgeting process.
1.4
a) 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; for example, a forklift truck versus a conveyor system to move materials, or a bridge versus a ferry boat.
b) Unlimited funds approach is used in a situation where a firm has an unbound pool of funds such that all independent investment proposals yielding a return greater than some predetermined and pre-specified level are accepted. The firm actually has more funds to invest than the proposals put forward. On the other hand, Capital rationing is where the firm has a fixed budget and funds are limited. Investment proposals actually compete for the limited funds such that the firm has to ration them. The firm is concerned with the selection of a group of investments options out of many proposals accepted under the accept-reject decision. This arises from a scenario whereby the firm has more acceptable investments than it can finance.
c) Unlimited funds approach is used in a situation where a firm has an unbound pool of funds such that all independent investment proposals yielding a return greater than some predetermined and pre-specified level are accepted. The firm actually has more funds to invest than the proposals put forward. On the other hand, Capital rationing is where the firm has a fixed budget and funds are limited. Investment proposals actually compete for the limited funds such that the firm has to ration them. The firm is concerned with the selection of a group of investments options out of many proposals accepted under the accept-reject decision. This arises from a scenario whereby the firm has more acceptable investments than it can finance.
d) A conventional cash flow pattern is a time series of outgoing and incoming cash flows that has only one change in direction or sign. For example, a project might have an initial outlay of $400,000 and then future cash inflows of $40,000 each year for the next 10 years. This would result in a cash flow pattern of -, +, +, +, +, +,+, +, +, +, + which is only one change in sign. An unconventional cash flow pattern is a series of cash flows
represents an unconventional cash flow pattern.
1.5
(a) Project s Payback Periods
Payback Period for Project H is 3, Payback Period for Project N is 2,
1.5
(b) Net Present Values(NPV)
Project H Project N Year (r=14%) (r=14%) 0 ($285 000) ($285 000) ($270 000) ($270 000) 1 100 000 87 719.28 110 000 96 491.23 2 100 000 76 946.75 100 000 76 946.75 3 100 000 67 497.15 90 000 60 747.44 4 100 000 59 208.03 80 000 47 366.42 NPV 6 371.23 11 551.84
1.5
(c) Internal Rate of Return (IRR)
Project
H Description Project N Description
14% Discount rate 14% Discount Rate
-285000 Initial Outlay -270000 Initial Outlay
100000 Return From 1st yr 110000
Return From 1st yr
100000 Return fron 2nd yr 100000 Return fron 2nd yr
100000 Return from 3rd yr 90000 Return from 3rd yr 100000 Return from 4th yr 80000 Return from 4th yr IRR H IRR N 15.09% 16.19% IRR = A + {a/(a+b)}(B-A) IRR for Project H is: 15.09% IRR for Project N is 16.19%
1.5 (d) Recommendations/Decision Making
Measure Project H Project N Decision
Payback Period 2.85yrs. 2.67yrs Choose Project N
Net Present Value $6 371.23 $ 11 551.84 Choose Project N Internal Rate of Return 15.09% 16.19% Choose Project N
the firm to recover its initial outlay and reinvest it elsewhere. A shorter payback period improves the general cashflow of the firm. For this reason Project N is selected.
Basing on NPV, all projects with NPV > 0 are desirable. However the higher the NPV the better and more desirable a Project is. Project N is chosen because of the higher NPV which is almost double that of project H.
Internal rates of return (IRR) are commonly used to evaluate the desirability of investments or projects. The higher a project's internal rate of return, the more desirable it is to undertake the project. For this reason, Project N was selected due to a higher return rate. Moreso, the IRR for Project N exceeds the cost of capital by 2.19% which makes it desirable.
For the above reasons and decision criterion: Project N is selected for implementation.
1.5 (e) NPV Profiles
