StudentShare
Contact Us
Sign In / Sign Up for FREE
Search
Go to advanced search...
Free

Theory of Capital Budgeting - Math Problem Example

Cite this document
Summary
According to the author of the paper 'Theory of Capital Budgeting', capital budgeting is the planning process used to determine whether a firm’s long-term investments such as new plants, new machinery, new product, etc. are worth pursuing or not. It is the process of selecting the best long-term investment proposal…
Download full paper File format: .doc, available for editing
GRAB THE BEST PAPER98.2% of users find it useful

Extract of sample "Theory of Capital Budgeting"

Part I: Theory 1. Research the topic of capital budgeting in general, and explain what it is, and why it is used. Capital Budgeting is the planning process used to determine whether a firm’s long term investments such as new plant, new machinery, new product etc. are worth pursuing or not. It is the process of selecting the best long term investment proposal which yield the most return over an applicable period of time. In other words, it is investment decision-making as to whether a project is worth undertaking. It is basically concerned with justification of capital expenditure. Its decisions are not equally essential and similar to all companies as its importance varies from company size, type of business, nature of industry and the growth rate of the firm. It is also “Investment Appraisal”. Why Capital Budgeting is used? Capital Budgeting is an important managerial tool. A firm has limited resources whether we consider its capital or assets which have some value in terms of money. Faced with limited resources, management of the firm has to decide about their best long term investment alternative which is economically acceptable and have high returns during an applicable period of time. Management of the firm can follow a sound procedure called Capital Budgeting to evaluate, compare and select from the set of alternatives. It helps to estimate the cash flow, access the cash flow risks, and determine appropriate discount rates, payback values etc. In other words, Capital is the main resource for a firm and Capital Expenditure has very large and significant impact on the financial performance of the firm, so the management has to take proper decisions before any investment and Capital Budgeting is the tool provided to them. 2. Define the time value of money and explain why it is necessary to consider this when making investment decisions. Time value of money is the value of money with the given amount of interest earned over a given amount of time. In simple words, it is a concept which addresses the ways of changes in the value of money over time. It is an essential part of the opportunity cost that will either give the decision maker the incentive or disincentive to bye a capital good. In Capital budgeting, it is a mechanism for investors to find the current value of a capital good against its value in the future. The concept of Time value of money is closely related to interest rate which leads to the discount factor. Why Time value of money is used? The investment decision involves selection between proposed options of capital goods and their replacement decisions. This selection requires judgments concerning future events which are unpredictable. For this one has to consider time and risk. So for that time, we want to know the present value of our money as well as the future value of the invested money that is how much interest we will earn and in case we are investing the current amount of money then are we getting the equal or more profit or benefit from the future amount of that money. It helps in taking decision whether we should invest in new project, in purchase of new machinery or on other capital goods or not. 3. Research the three main methods of capital budgeting. Make sure you specify the name of the method, how it works, an example, and advantages and disadvantages. The three Capital budgeting techniques are: Payback Method, Net Present Value (NPV) Method, and Internal Rate of Return (IRR) Method These methods have their own pros and cons but all the three methods are used to derive a decision to accept or reject the proposal of new investment. Payback Method: Payback method is concerned with the number of years will take to recover an initial investment. It helps in evaluating projects risk and liquidity, faster rate of return and faster recovery of funds. It is calculated as: Payback period = Expected number of years required to recover a project’s cost Example: There are two projects Project A and Project B available for a company, with a life of 6 years each and required a capital of $9,000 each and additional working capital of $1000 each. The cash inflows comprise of profit after tax + depreciation + interest (tax adjusted) for five years and salvage value of $500 for each project plus working capital released in the 6th year. The company has prescribed a hurdle payback period of 3 years. Which of the project should be selected? Project A Project B Investment 10,000 10,000 Cash Inflow 6 years 6 years Year 1 3,000 2,000 Year 2 3,500 2,500 Year 3 3,500 2,500 Year 4 1,500 3,000 Year 5 1,500 3,000 Year 6 3,000 5,500 Answer: Year Project A Cumulative cash inflows of Project A Project B Cumulative cash inflows of Project B Year 1 3,000 3,000 2,000 2,000 Year 2 3,500 6,500 2,500 4,500 Year 3 3,500 10,000 2,500 7,000 Year 4 1,500 11,000 2,500 9,500 Year 5 1,500 13,000 3,000 12,500 Year 6 3,000 16,000 5,500 18,000 Payback Period of Project A = 3 years (cumulative cash inflows = outflows) Payback Period of Project B = 4 years (cumulative cash inflow $9,500) + (10,000-9,500) *12 /3000(where 3000 is cash inflow of year 5) months = 4 Years and 2 Months So, the company should select Project A with a Payback Period of 3 Years as its main rule is to recover the investment as early as possible. Advantages: Easy to use and understand Effectively handles investment risk Good approach when a weak cash-and-credit position influences the selection of a proposal Can be used as a supplement to other techniques, since it indicates risk Business enterprises facing uncertainty – both of product and technology – will benefit by the use of payback method since the stress in the technique is on early recovery of investment. Liquidity requirement requires earlier cash flows. Hence, enterprises having high liquidity requirement prefer this tool since it involves minimal waiting time for recovery of cash outflows as the emphasis is on early recovery of investment. Disadvantages: Ignores the time value of money Does not consider cash flows received after the payback period Does not measure profitability Does not indicate how long the maximum payback period should be Penalizes projects that result in small cash flows in their early years and heavy cash flows in their later years. Does not consider Rate of Return. Net Present Value (NPV) Method: NPV of an investment is the difference between the sum of the discounted cash flows which are expected from the investment and the amount which is initially invested. In other words, it indicates the value which an investment or project will adds to the firm. This is done by measuring all cash flows over time back towards the current point in present time. Computation of Net Present Value Each cash inflow/outflow is discounted back to its present value. Then they are summed for NPV. Therefore NPV is the sum of all terms , where t – the time of the cash flow i – the discount rate( rate of return that could be earned on an investment in the financial market with similar risk.) Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t (for educational purposes, R0 is commonly placed to the left of the sum to emphasize its role as (minus the) investment. The result of this formula if multiplied with the Annual Net cash in-flows and reduced by Initial Cash outlay will be the present value but in case where the cash flows are not equal in amount then the previous formula will be used to determine the present value of each cash flow separately. Any cash flow within 12 months will not be discounted for NPV purpose. If… It means… Then… NPV>0 The investment or project would add value to the firm the investment or project proposal should be accepted NPV Read More
Cite this document
  • APA
  • MLA
  • CHICAGO
(Financial Management (problem Solving) Example | Topics and Well Written Essays - 4629 words, n.d.)
Financial Management (problem Solving) Example | Topics and Well Written Essays - 4629 words. https://studentshare.org/other/2044479-financial-management-problem-solving
(Financial Management (problem Solving) Example | Topics and Well Written Essays - 4629 Words)
Financial Management (problem Solving) Example | Topics and Well Written Essays - 4629 Words. https://studentshare.org/other/2044479-financial-management-problem-solving.
“Financial Management (problem Solving) Example | Topics and Well Written Essays - 4629 Words”. https://studentshare.org/other/2044479-financial-management-problem-solving.
  • Cited: 0 times

CHECK THESE SAMPLES OF Theory of Capital Budgeting

Theory of Budgetary Processes

With the help of capital budgeting, evaluation of investment proposals can be done easily in the best possible way.... In capital budgeting, the speed of evaluation process gets geared up as by using this method; those proposals are top ranked which include no real choice for example replacing a leaking sewer line with an updated one, as this one will remove any... budgeting [Author] [Institution] budgeting Keeping a budget the moment you start a business is one of the cleverest steps to begin with....
3 Pages (750 words) Coursework

CAPM ana Capital Budgeting

CAPM and capital budgeting The objective of the present paper is to discuss the efficacy of the Capital Asset Pricing Model (CAPM) in the context of capital budgeting by firms.... In particular the merit of the arguments put forward by Jagannathan and Meier (2002) in the article titled “Do we need CAPM for capital budgeting” shall be evaluated in the context of relevant literature.... The typical textbook solution to capital budgeting is through computing the Net Present Value (NPV) of a project by using the cost of capital as the discount rate to identify the projects that lead to maximization of the value of the firm....
3 Pages (750 words) Essay

Capital Budgetting of Caledonia Products

CAPITAL BUDGETTINGH OF CALEDONIA PRODUCTS INTRODUCTION This report addresses capital budgeting for Caledonia Products.... Company is planning to introduce new product to the market and company seeks to analyze the investment opportunities by using capital budgeting techniques.... capital budgeting technique use to evaluate investment proposal with respect to their feasibility.... A- Caledonia Products should focus on free cash flows for evaluation of the project investment as compare to accounting profit in capital budgeting decision....
5 Pages (1250 words) Research Paper

Corporate Finance: Traditional Capital Budgeting

The main objective of capital budgeting is to allocate firm's limited resources between competing opportunities (Harrison & John 2010).... Corporate Finance: Traditional capital budgeting ... Corporate Finance: Traditional capital budgeting ... Management use various capital budgeting techniques to make effective use of these resource to maximize firm's value (Bennouna, Geoffrey & Marchant 2010).... Though there are several capital budgeting Techniques, However this document shall emphasizes on significance and limitation of Traditional Budgeting Techniques (Bennouna, Geoffrey & Marchant 2010)....
6 Pages (1500 words) Essay

Financial Management Principles

capital budgeting is a process that requires decisions regarding the investments in financial assets while forecasting of financial statements involves approximation of future financial statements.... Hence capital budgeting is a whole p[process of analyzing the projects their cash inflows and outflows and deciding which one is to included in the capital budget and which one is to be rejected.... capital budgeting analyzes the various options to fill in this need of fixed assets and decides upon the capital projects which will be the part of organization's fixed assets in future....
2 Pages (500 words) Essay

Capital budgeting

The present essay "Capital budgeting" dwells on the concept of capital budgeting.... capital budgeting.... However, it has the limitation of not taking into account the scarcity of capital, and secondly, it's overly simple (Baker and Kent 2005 pp.... It is calculated NPV =∑_(n=0)^N▒Cn/〖(1+r)〗^n = 0 Which is equivalent to NPV/(1+IRR)^year) of all positive and negative cash flows While evaluating investments using IRR any project which has an internal rate of return greater than the opportunity cost of a project usually taken to be a weighted average cost of capital-WACC are accepted....
3 Pages (750 words) Essay

Capital budgeting

Unlike IRR and Payback techniques, the NPV is a very accurate tool that helps to determine if the project will be capital budgeting capital budgeting EEC calculation for NPV, IRR, and Pay Back for the investment opportunity YEAR CASHFLOWRATE OF DISCOUNTING=14%=(1+r)-nNPV0($2,000,000)1($2,000,000)1$500,0000.... EMOTo: EEC PresidentFrom:Date:Subject: capital budgeting(a) EECs cost of capital increases The president of EEC should be aware that if the cost of capital increases as discussed above, the underlying effect is a negative NPV....
2 Pages (500 words) Essay

Managerial Economics and Capital Budgeting

One such discipline in managerial economics that I found cumbersome is 'capital budgeting.... capital budgeting is the multi-stage process of analyzing and appraising what resources and whether they should be allocated to existing projects.... It The paper "Managerial Economics and capital budgeting" is a wonderful example of an essay on macro and microeconomics.... One such discipline in managerial economics that I found cumbersome is 'capital budgeting....
2 Pages (500 words) Essay
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.
Contact Us