Capital budgeting

1. Introduction

The problem of capital budgeting was formulated in 1955 by Lorie and Savage and it came to be recognized as a model of providing solutions for financing and investment problems (Salo, 2011) .Firms use capital budgeting as tool of evaluating viability of an investment project to be undertaken and in deciding between two or more options for investment projects. Determining whether benefits of an investment project are higher than the costs involved requires that a financial manager should have an estimation of expected cash flows relating to the investment. In case of a capital project, the process normally entails and estimation of costs and revenues of future periods. The financial manager has to also incorporate taxes into the said cash flows since this forms a basic part of future cash flows. This paper includes an analysis capital budgeting , the techniques and methods used in capital budgeting , importance of capital budgeting in decision making and risks management and illustration of capital budgeting for a company opening a new branch.

 The evaluation of the investment viability is done through various techniques that show the period and extent to which investors’ funds will be recovered and profit earned from the projects. These techniques includes payback period and discounted payback period approaches, net-present value, profitability index, internal rate of return , modified internal rate of return and average accounting returns methods. The decision made concerning capital investment affect organizations for years and hence there is a need for careful capital budgeting process. The various decisions made through capital budgeting process comprises of allocation of limited resources, buy vs. lease decisions and comparing various investments that have different lives. Capital budgeting process is also incorporated in risk management in firms since any investment decision made that is exposed to risks. This incorporation entails considering future cash flows, risks presented by such cash flows and the cash flows value.

2. Definition and theory

Capital budgeting refers to a process used by organizations or business in determining the merits of a specific investment project. It is a process in which organizations assesses its potential investment or expenses  that are quite large and such investments and expenditures include projects like  construction of new plants or a long-term venture. Firms constantly invest their funds in some assets and these assets yield cash flows and income which the firm may reinvest further into assets or pay to shareholders. The assets represent the capital of the company and capital investment indicates the investing in the company’s assets (Salo, 2011). Capital project refers to a given asset investment set considered to be dependent on one another and decision makers consider them together.  Financial managers in the company must evaluate investment decisions that relate to long-term assets and other such investments in the capital budgeting process so as to generate value for shareholders or owners of these assets (Salo, 2011).

 The consideration of the investment project  including  whether it should be accepted or abandoned as  a part of initiatives carried out by the business for the purpose of growth is informed by capital budgeting. Through determining the rate of return that will be generated by the investment, the decision is made.  The general notion involves the fact that capital in terms of long-term funds that  an organization raises are used in funding investments that will make it possible for it to generate income in a number of years in the future. In most cases ,the money raised for investing in such assets are not normally unrestricted or available infinitely and hence , the company has to budget how such funds are going to be invested (Besley & Brigham, 2013).

The people who normally generate capital budgeting project ideas are usually the employees, suppliers, customers and other stakeholders and such ideas are based on the experiences and needs of the organization and such groups of individuals. For instance, sales representatives may constantly hear from customers that they need of products having specific characteristics that are not found in the current products of the firm. The idea is represented to the management by the sales representative and the management evalutate whether the idea id viable through consultation with engineers and production department. If the idea is confirmed to be viable, the financial manager has to conduct an analysis of capital budgeting to make sure that the project will bring substantial benefits in line with the company’s value (Besley & Brigham, 2013).

3. Capital budgeting techniques

 The techniques used in capital budgeting depends on the industry but for every technique cash flow from every investment is determined and then uncertainty of the cash flows are assessed so as to evaluate  various investment projects and choose those projects that will maximize wealth. It is good to look into how well every technique used discriminates among different investment projects and finally getting projects that will achieve maximum benefits to the wealth of the owner. Various criteria should be met by the capital budgeting evaluation technique and this include; considering every  cash flow that is incremental from a particular  project in the future; take into account value of money overtime; take into account uncertainty related to the cash flow in the future; presence of an objective criterion for selecting a project (Clayman, Fridson & Troughton, 2012).  If a project is selected using the highlighted criteria, it will generally lead to maximum wealth for the owner.

1. Payback period technique

Normally the payback period of a specific project is normally the time running from the first cash flow for investing in that project until such a time when cash inflows of the project equals the starting cash outflow. This basically refers to the time taken by the project to return the initial money invested. The payback period is hence the period for capital recovery or the payoff period (Besley & Brigham, 2013). If the investment consisted of $10,000 presently and the returns are $5,000 after one year and $ 5,000 after 2 years, the payback period is therefore, 2 years.  This technique does not have a decision criterion that is well-defined and usually favors those projects having cash flows that are “front-loaded”.  For an investment, it will look better in relation to payback period immediately the cash flows are received regardless of how the later cash flow appears. An analysis using payback period is firm if break-even measure that seems to offer a measure of a project’s investment’s economic life measure in relation to payback period.  If the economic life is likely to surpass the payback period, the investment is more attractive and if the post-payback period is equal to zero, such an investment is considered worthless regardless of how short the payback period is (Besley & Brigham, 2013). This can be attributed to the fact that total future cash flows are not higher than the initial investment.  Given that the future cash flows are actually worthless currently that in future, a post-payback duration that adds up to zero means that current future cash flows value is lower than initial investment of the project.  This technique provides some suggestions about the project’s risks.  In a sector where the equipment becomes rapidly obsolete or where there is cut-throat competition, investments whose payback is achieved earlier are of higher value.  Since the payback technique does to how the specific payback duration, in which wealth is maximized, it cannot be used as the basic evaluation method for investing in long-term assets (Besley & Brigham, 2013).

1. Discounted payback period technique

This is a method that involves looking into how much time would be required for a project to provide returns for the initial investment while considering the TVM (time value of money).  Discounted payback duration refers to the time it would take for the first investment to be paid back in relations to discounted cash flows for the future.  It involves discounting every cash flow back to the starting of the said investment using a rate that point to future cash flows uncertainty and time value of the funds. The rate connotes the cost of capital and if the future cash flows cannot be certain, the cost of funds invested is higher (Besley & Brigham, 2013).  If the uncertainty is high, that cash flow is worth less presently, meaning that a greater rate of discount is utilized for translating into the current value.  The discount rate is a reflection of the funds’ opportunity cost and for a firm, that opportunity cost can be considered for capital providers who include owners and creditors. If the payback period is shorter, the techniques can be used successfully, even though determining how short is better is difficult. However, the breaks-even in relation to discounted cash flows at the point of discounted payback involves the point at which discounted cash flows adds up to invested funds (Besley & Brigham, 2013).

• Net –present value

This technique is quite common and can be used more effectively in carrying out investment evaluation. For calculation using net present value to be carried out, a calculation of the different between investment cash outflows (projected cost) and cash inflows (cash flows that are generated by the investment project) is done. This technique is quite effective since it utilizes an analysis based in discounted cash flows, and where a discounted rate is used to discount expected cash flows so that the uncertainty of the said cash flows can be compensated (Besley & Brigham, 2013). A case in example is where an investment project costs $ 5,000 presently and offers to repay 7,000 dollars in 2 years time with an opportunity cost being 10 % .To find whether the investment is viable involves a comparison of the $ 5,000 with $ 7,000 as the cash flow expected in 2 years. The current value future cash flow can be obtained as $7,000 / (1+ 0.10)² which results to $ 5,785.12 .Hence, a 5000 investment today will yield a cash flow that will be worth $5,782.12 in future.  The term “net” in shows that each cash flow regardless of whether positive or negative will be considered. A net present value that is positive means that the value of the company will be increased by the investment and such a return is more that what is needed to compensate for expected investment return. On the other hand, if the net present value is negative, it means that the value of the company is reduced by the investment since it is lower than capital cost and hence should be rejected.  If the present value is zero, it means that obtained returns are just sufficient to recover the capital cost involved in the investment project and to compensate for the uncertainty level for future cash flows of the investment and time value of money. The decision for the investment project in this case can be indifferent between accepting and reject it.

1. Profitability index

This technique utilizes information similar to the one used in NPV but in this case in form of an index. If the value of the profitability index is more than 1, it means that the investment produces more profits or returns that the cost involved (Clayman, Fridson & Troughton, 2012).

1. “Internal rate of return”

This is basically a discount rate used in determination of how much returns can be expected to be realized from a given investment. It is that rate of discount that occurs after an investment reaches a break-even or when the net present value if the investment equals zero. The decision rule in this case involves selecting a project with a greater Internal Return Rate than financing cost. The Internal Rate of Return refers to proceeds or average earnings per year (Besley & Brigham, 2013).  If the cost of financing is 5 %, the projects are not accepted unless this rate of return is more than 5 %.  An investment project will be highly attractive if there is a big difference between the internal rate of return and the cost associated with capital. When dealing with independent investment project, the decision rule is quite straight forward but can be quit tricky in the case of investments that are mutually-exclusive.

 There is a likelihood that two mutually exclusive projects will have  Net present Value (NPV) and Internal Rate of Return  that are conflicting and this means that one such project will have a lower IRR but at the same time higher Net present value when compared to another one. Such issues may result from original investments between two projects not being equal, but despite such issues, the technique is useful for business analyses (Besley & Brigham, 2013). A choice for a venture that has a greater net present value leads to maximization of shareholders wealth since a discount rate can be used for calculating various NPVs and obtain a completely varying conclusion.  Hence while using this technique to evaluate different projects, one may choose a project that will not maximize value. In relation to Net Present Value , if the best that can be done is to  have cash flows reinvested at the financing cost , NPV will assume the project at financing cost ( capital cost ) which is a bit reasonable. If the rate of reinvestment is taken to mean capital cost, the investment project will be evaluated on NPV basis and choose the one that will maximize the wealth of the owner.  The internal rate of return technique may not be fit if there is more than one change in cash flows resulting from investment project’s life (Besley & Brigham, 2013).

 

1. Modified Internal Rate of Return

This technique is utilizes the function of both cash flows pattern and reinvestment rate and greater reinvestment rates resulting to bigger modified rate of returns. In case the Modified Internal Rate of Return (MIRR) is larger than invested money, there is expectation of more returns that is needed and such an investment should be accepted. If the MIRR is less than financing cost, the expectation is that returns will be less than require hence, it should be rejected. If the return rate equals the capital cost, the expectation is that returns will be equal to returns required and indifference exists between rejecting and accepting the investment (Clayman, Fridson & Troughton, 2012.

• Average accounting returns

 This refers to a method of accounting that is used for comparing various capital budgeting calculations like IRR and NPV. This technique provides a fast approximation of an investment project worth during its valuable duration. In this case, calculation of Accounting Rate of Return is done through finding the average operating profits of capital investment before interest and taxes but usually before amortization and depreciation (EBIT) and dividing it with book value of the average total investment and the results expressed as percentage (Besley & Brigham, 2013). The decision rule for the project involves accepting an investment whose ARR equals or higher than the needed ARR. In there are investment projects that are mutually exclusive, the one that has highest ARR is accepted. However, this technique has various disadvantages since its basis is book value, but not market value and cash flows, and it does not take into account the TVM (time value of money )(Besley & Brigham, 2013).

 

Method	procedure		decision
Pay period method	Cost of investment/annual net Cash flow	$16000/$4100	39 Years
			Period for initial investment recovery
Net present value	Future net cash flows discounted at required return rate less initial investment amount		If expected cash flows of an asset are discounted at set rate and results to positive net present value , investment should proceed
Internal Rate of Return	-Computation of investment’s present value factor -identify Internal Return Rate (discount rate) that will give present value factor		Investment with lower risk need lower rate than those with higher risks
Accounting rate of return	Annual after tax income /annual average investment	e.g $2100/$800	26.25 % - management decides whether the rate is satisfactory

 

 

 

4. Importance of capital budgeting

Organizations are affected by capital budgeting decisions for some years and hence careful planning is very essential. If the decision is bad, it can significantly affect the future operations of a firm and the timing of the decision is quite important.  Capital budgeting is an essential aspect of planning since it creates measurability and accountability of any business that wants to invest its financial resources in a specific project.  If the business does not understand the returns and risks involved in any given project, the management will be held accountable to its shareholders (Besley & Brigham, 2013). Moreover, if a firm lacks a mechanism of measuring or evaluating the effectiveness of the different investment decisions made, there are high chances that the business will not compete effectively in the market. The process of capital budgeting is therefore, a good measuring technique that firms can use in determining the long-term economic and financial performance of an undertaken investment decision (Besley & Brigham, 2013).

Decision based on capital budgeting affects the firms in the long term and more specifically, the future growth and cost structure.  If a resolution is made wrongly, it can be disastrous for the continued existence of a company in the long-run. If there are no investments on assets, the competitive position of an organization will be negatively influenced. It is a tool used by organizations to come up with and develop long-run strategic goals of a company, an important aspect given that a company’s ability to set goals important to its prosperity and growth.  It offers the business a capacity to appraise its investment and hence creating a platform for planning the long-term direction. Capital budgeting is essential in managing big amount of financial resources through a capital outlay (Besley & Brigham, 2013) .A thoughtful and correct decision since wrong decisions may lead to large losses and hinder the organization from earning profits out of other investments which were foregone.  The capital budgeting process assist a firm with an aim of expanding to look for new projects for investment and knowing how such investment can be evaluated provides a model for assessing the viability of new projects (Besley & Brigham, 2013).  The business is able to undertake those projects that will give it a competitive edge in an industry and hence improved profitability in the industry.

 In addition, capital budgeting assist firms in estimating and forecasting its future cash flows, which are the aspect that generate value for a business over a given period of time. The management is able to undertake a potential investment and project the possible future cash flows and these in turn assist in determining where to accept or reject the project. This also relates to uncertainty and risks that a business faces in the industry and overall market and capital budgeting comes in to help in evaluating the possible future outcomes. Business decisions made by managers are surrounded by big uncertainties and there is a need for a tool to measure investments decisions in light of the aforementioned risks and uncertainties (Besley & Brigham, 2013). Investment involves both the present and the future and capital budgeting helps management to evaluate how the investment to be undertaken can fair amidst possible risks. This especially true if the investment project is being undertaken over a long period of time because the longer the period for specific project the more uncertainties and risks it is likely to encounter.

Capital budgeting is important in a business since it act as a tool for transferring information required by owners and stakeholders.  From the moment an investment project is initiated as business idea to the time it gets to be accepted or rejected , management has to make many decisions and the information required for such a decision can be provided  through capital budgeting.  The process makes it possible to transfer the required information to the relevant decision makers with all levels of an organization. This includes transferring information to shareholders whose equity value is influenced by the investment decisions taken (Besley & Brigham, 2013).  The capital budgeting tool is also essential in maximizing the shareholders’ equity worth since decisions on fixed assets acquisition are informed by the information provided by this process. The process if also useful when it comes to monitoring and controlling of investment expenditures since through careful definition, the required expenditures and also research and development are identified. A venture may turn worthless if unnecessary expenditures are not monitored and controlled in a careful and effective process, a crucial aspect of capital budgeting (Besley & Brigham, 2013).

5. Capital budgeting in decision making
6. Allocation of limited funds

In many cases, investment decisions involve allocation of limited resources among various potential investments. Since funds are normally not enough for funding all the investments, a decision is needed to determine the investment to be given priority.  The kind of analysis needed for such decision depends on whether these investments are divisible or indivisible.  In this regard, a divisible investment refers to those whose funding can be partial and economic benefits created equals the funds invested (Petty et. al 2015). For instance, if the funding of an investment is only 50 percent of all investment, it will only result to 50 percent of returns. However, most investments are normally not divisible and hence, the whole investment has to be done before any benefits can be obtained. In such a case, an investment or a given group of investment is selected if they give the greatest net present value.  This kind of analysis assumes that after investments, there is not going to be a return on resources remaining (Petty et. al 2015).

1. Buy vs. Lease decision

 A capital budgeting process is used for comparing different methods of obtaining an asset whether an equipment or a machine. The asset can be obtained through purchasing using outside funds, with no outside fund or through leasing. Even though the asset can be obtained in different ways, the operating expenses, output level and other aspect are similar for the alternatives but such aspects are not normally relevant to a comparative analysis and hence, are not at all included.  In this analysis, the discount rate indicates the capital’s opportunity cost. The ranking of the cost in terms of present value is done to show the method of obtaining the asset and which alternative is going to give the least cost of accessing the asset (Petty et. al 2015).

• Comparison of investments that have different lives

Comparison of alternative investments that have different lives is a common problem in capital budgeting and to obtain accurate comparison of investments by use of discounted cash flows, there is a need to have the same lives of the investments (Droms & Wright, 2010). A replacement chain method may be used.  For instance, if a machine is to be purchased to replace one that is worn-out, one of the options may be buying a machine with a lifespan of 10 years and costing $250,000. Another option would be to buy an economy machine that is cheaper costing only $ 160,000 but lasting only 5 years. The first machine brings about $60,000 cash flows annually in 10 year duration; this is on the basis of net cash flow amounting to $ 350,000 in a period of 10 years. The present value for the machine will be about $ 118, 674  cash flow in present value which is way less than nominal amount since outflow is seen at the beginning but inflows occurs over the whole period and at the same time are discounted. On the other hand, the economy machine is bough at the start of the period while replacement is done at the end of 5 years with a similar one.

Hence, the life of this replacement chain equals that of the first long life machine. Higher present value will be generated for the first machine - $118,674 cash flow – than the economy machine - $ 109,327 cash flow. This means that the relative advantage for using the lifelong machine is greater than the economy machine. This shows the need of capital budgeting in deciding which assets having different lives that a company should invest in so that to obtain the highest possible benefit from such an asset. The analysis is important for management when carrying out investment decision so that to ensure that limited resources are utilized to purchase assets that will give maximum value for shareholders of a business.

6. Capital budgeting and investment risks

The decisions on capital budgeting made by a financial manager requires an analysis of every investment option or option. This involves considering future cash flows, risks presented by such cash flows and the cash flows value. When looking into investment opportunities available, the aim is to determine the project that will provide maximum value for the firm and hence maximum wealth of owners. When estimation is made on what it would cost to invest in a certain project and the future benefits, there is also coping with risks or uncertainty. The uncertainty emerges from various sources and this depends on the type of investment project  in question , the industry and circumstances under which a firm is operating (Baker, 2011). The risks may arise from economic conditions, market conditions and government policies involving tax rates, interest rates and even international conditions.  The source of uncertainties affects the future cash flows and for the purpose of evaluating and selecting among investment options that will give maximum wealth for shareholders, there is a need for assessing risks related to the cash flow of a project.  Evaluation of capital project involves measuring the concerned risks. Any financial manager could worry about investment risk since owners and creditors – who supply the capital – must get compensation for the risk taken (Baker, 2011). Theses financiers can either provide their resources to the firm for investment or they can choose to invest elsewhere. This shows the existence of an opportunity cost that should be considered and include what the capital suppliers could gain elsewhere for similar degree of risk. The cost of capital, therefore, includes compensation for risk taken and Time Value of invested money.  The reward for such risk is the premium or the extra return needed for compensating capital suppliers the risk they bear and amount of risk compensation is assessed by understanding that the company’s assets resulted from past investment decisions (Baker, 2011).

While investing in stock market, the providers of capital will also demand for the risk they have undertaken and the bigger the risks of a particular venture, the higher the compensation required and the higher the capital cost. The reward for time value for money involves compensation for expected inflation and time value for money can be represented using an interest rate that is risk-free.  The compensation for such risk refers to additional return needed since the future cash flows for the investment project are not certain (Baker, 2011). If an assumption is made that applicable risk involves stand-alone risk like in the case of small business that closely held, and the capital providers would demand a greater return, the higher is the stand alone risk for the investment. If it is assumed that involved risk is market risk for the investment and the capital providers would demand higher return, the marker risk for the project would be greater. The capital budgeting tools or techniques are available for managers as decision makers to evaluate and measure the risk of an investment project even though most of currently used techniques are subjective (Baker, 2011).

 Firms that employ discounted cash flow methods like net present value (NPV) and Internal Rate of Return are likely to use a single capital cost, but this can be dangerous when used for all investment project. What if a single capital cost was to be used for all projects; if they all have similar level of risk and capital cost used for such risk level is appropriate, there would be no problem. A problem would arise if single capital cost was to be used for projects with varying risk levels.  If the capital cost used is capital cost for average risk investment for a firm, the use of discounted cash flow methods will lead to unwise decisions (Droms & Wright, 2010). Such decisions include rejection of profitable investments having lower risks than average risk investment since the future cash flows were too much discounted. The other such decision include acceptance of investments that are unprofitable and with higher risk than average project since there was not enough discounting of future cash flows( Droms & Wright, 2010).  Hence, incorporating of risk is important in capital budgeting process but judgment based on high level of experience is more applicable than scientific risk incorporation methods. It is also possible to that ignoring a more technical analysis of and using a total subjective risk assessment in estimating cost of capital that will provide a better reflection of investment risks.

Selecting and screening of investment projects requires financial managers to estimate the anticipated cash flows for every project, appraise the level of risk for the cash flows and assess the contribution of every project to the value of the firm and hence, hence to the owners.  The budgeting process must incorporate risk in their analysis of the investment options for the purpose of identifying the ones that will offer maximum value for shareholders.  Risk is basically  involved in decision making process by using a capital cost that indicates the risk of the investment project .The risk that is relevant for appraising an investment project is the market risk and which is normally estimated by examining other companies’ market risk in the same industry as the intended investment (Droms & Wright, 2010).

The capital budgeting process is therefore, important in determining the risks that face various investment options and taking into account the options whose risk is worth taking. The investments that are relevant in terms of risk taken are those that providers of capital are assured of obtaining return on capital and profitability. There is not investment project that is free of risks and such risks may vary depending on the type of investment.  The different risks includes lack of timely payment of cash flow , risk of collapse of the investee  company  and the likely risk of management using the investment funds in startups or projects  whose risks are not easily covered.  Incorporating risks into the capital budgeting process is, therefore, important in minimizing losses for the investors. Risk adjustment can also be done in capital budgeting so that various investment projects can be compared under different situations in the market (Droms & Wright, 2010). Capital budgeting process carried out under uncertainty can be approached through different ways and in a broader sense if the decision based on capital budgeting is placed within risk management framework.

7. Capital budgeting in company expansion

Company expansion through opening a new branch is among the major projects that may be undertaken with an aim of value addition to organization. The reason for expansion may include improving the production capacity or targeting a specific market regionally or globally. Expansion efforts undertaken by a company involves large expenditures due to the need for fixed assets like acquisition of machinery, purchasing new equipments and vehicles and the construction of a plant. It also involves expenditures on revenue for the purpose of starting off operations and meeting other necessary requirements like transportation.  This requires an effective process of capital expansion in order to improve the whole timing of acquisition of assets, carrying out risks assessment and deciding the best investment options in terms of acquiring the appropriate assets (Petty et. al 2015).

Opening of the new branch would require a company to evaluate the decision in terms of the aimed returns from the expansion and any risk involved in investing huge amount of money in a new branch. It, therefore, involves identifying the needs for the facility in terms of evaluation of all the requirements. The decision making will therefore, involve evaluation of how much funds is required and how much is to be used in the new investments and the providers of such amount of funds.  Opening of the new branch will involve broadening of the existing line of products and even the market. The aim of expansion projects involves minimal risks since a company that has history of experience in the market can make cash flow estimation with certainty (Petty et. al 2015). This is unlike introducing a new product line or entering a new market.

8. Replacement project – Replacing old machine with new

Capital budgeting process is also an important tool in making decision on asset replacement, where the existing assets are replaced with new ones but which carries out the same function. During replacement, there is an expectation that cost of production reduction will be achieved rather than enhancing the sale of company’s products (Petty et. al 2015).

Example details

Facts: new machine

Purchase price - $ 380,000, Installation cost - $ 20,000, Depreciation period – 5 years

Old machine purchase cost - $ 240,000 - 3 years ago and depreciation 5 –year class rate

Additional $ 35,000 expected in current assets, $18,000 current liabilities for new machine

Tax bracket for the firm 40 percent for capital gains and ordinary income

 Possible sale price for old machine - $ 280,000

 

 

 

 

Cash flows

Old Equipment
	000'	000'	000'	000'	000'	000'
year	-2	-1	0	1	2	3
beginning book value	240	192	115	69.6	40.8	14.4
Rate of depreciation (%)	0.2	0.32	0.19	0.12	0.11	0.06
Depreciation expense	48	76.8	45.6	28.8	26.4	14.4
End year book value	192	115.2	69.6	40.8	14.8	0
New equipment
Year	-2	-1	0	1	2	3
Beginning book value	400	320	192	116	68	24
Rate of deprecation (%)	0.2	0.32	0.19	0.12	0.11	0.06
Depreciation expense	80	128	76	48	44	24
End year book value	320	192	116	68	24	0
Year 0- initial cash flow
new machine new cost		400,000
Present machine sales after tax
Price of sale			280000
Book value			-69,600
Amount taxable			210400
Tax - 40 percent			-84,160
Net working capital change
Current assets increment		35,000
Current liabilities increment		-18,000
		17,000
Initial investment	195840+17000	221,160

 

 

INCOME STATEMENT

Present machine
Year	000'	000'	000'	000'	000'
Revenue	2,520	2,520	2,520	2,520	2,520
Expenses	2,300	2,300	2,300	2,300	2,300
Profit before Int&Taxes	220	220	220	220	220
Depreciation	80	128	76	48	44
Net Profit before Taxation	140	92	144	172	176
Taxes	56	36.8	57.6	68.8	70.4
Profit After Taxation	84	55.2	86.4	103.3	105.6
Depreciation	80	128	76	48	44
Operating Cash flow	164	183.2	162.4	151.2	149.6
Old machine	000'	000'	000'	000'	000'
Revenue	2,200	2,300	2,400	2,400	2,450
Expenses depreciation excluded	1,990	2,110	2,230	2,250	2,350
Profits before depreciation and taxation	210	190	170	150	100
depreciation	28.8	26.4	14.4	0	0
Net profits before taxation	181.2	163.6	155.6	150	100
Tax	72.48	65.44	62.24	60	40
Net profits after taxation	108.72	98.16	93.36	90	60
+ Depreciation	28.8	26.4	14.4	0	0
cash inflows (operating)	137.52	124.56	107.76	90	60
Increased  operating cash flows	26.48	58.64	54.64	612	896
Terminal cash flows
sale of new machine - proceeds	returns	50,000
Taxation	Book value	24,000
		26,000
Returns after tax proceeds	50000- 10400	39,000
new machine  change in net working capital		17,000
		56,000

 

Cash flow projection
Year	0	1	2	3	4		5
initial Investment	221160	0	0	0	0		0
cash flow- operating	0	26480	58640	54640	61200		89600
cash flow - terminal	0	0	0	0	0		56600
Relvant cash flow	-221160	26480	58640	58640	54640		61200
Analysis	NPV =	25,006

 

Decision – since NPV is greater than Zero, accept the investment

 

9. Issues in capital budgeting

There are a range of challenges involved in capital budgeting return dimensions while increasing precision of related theory appears to obscure some primary issues in capital budgeting decisions.  The biggest challenges in the process relates to estimation of cash flows, timing of the cash flows and their uncertainty level. Little attention is placed on these issues in theory setting while much effort is focused on the importance. In analyzing cash flows in capital budgeting process , there should be a  joint consideration of return and risk as financial managers are using techniques such like discount rates that are risk-adjusted, certainty equivalents and the like in  recognition and adjustment for possible problems   of cash flows (Laux, 2011).  Another factor that complicates the process is Corporate Income Tax since it has an effect on cash flows and tax-related problems for decisions like replacement of equipment may be involved. One of the major challenges of all the issues comprises of behavioral and personal aspect in long-term allocation of capital (Laux, 2011).  These challenges have to be looked into by management since implications of capital budgeting covers almost all long-term investment decisions carried out by the firm.

References

Salo, A. (2011). Portfolio decision analysis: Improved methods for resource allocation. (Portfolio Decision Analysis.) New York: Springer.

Laux, J. A. (2011). Topics in Finance: Part VI-Capital Budgeting.

 

Besley, S., & Brigham, E. F. (2013). Principles of finance. Cengage Learning. 493-520

 

Clayman, M. R., Fridson, M. S., & Troughton, G. H. (2012). Corporate finance workbook: A practical approach. Hoboken, NJ: Wiley.

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