# Important information about Capital budgeting proposals

The CEO has given you 3 different large projects he's evaluating to see which might be most beneficial to the company to invest in. These include:

A new labor-saving piece of equipment that cost $400,000 and will reduce labor and quality costs by $75,000/year for 6 years.

A new marketing program, costing $500,000 is expected to increase current sales of $10,000,000/year by 30% for the next 4 years only. The current contribution margin of 30% will remain in effect even with this sales increase.

Launching a new product will cost $600,000; the product is expected to sell for $15/unit at a volume of 20,000 units/year for 3 years, at a 40% contribution margin.

The firm's overall cost of capital is 10%.

As a follow up to your capital budgeting analysis, the CEO asked you to write a memo addressing these specific questions:

Why does a firm need to have a capital budgeting process?

What is/are the 3 primary methods of capital budgeting?

The pros and cons of each?

The method you feel is the best and why do you think so?

Is it better for the firm to have a higher or lower discount rate (or cost of capital)? Why?

What could happen if you pick a discount rate that is too high?

Submit 1+ page of calculations including the following:

For each proposed project, use the following 3 methods of capital budgeting:

Simple payback: Normal target for project approval is 2 years or less.

Net present value (NPV): Approval requires at least that NPV > 0.

Internal rate of return (IRR): Project approval requires that IRR at least exceed the firms minimum required return of 20%.

Based on your calculations, make a decision about which of the 3 projects listed is best and explain your reasoning.

Assuming all 3 of the projects has a much lower risk than your everyday running of the business: How would you factor different levels of risk into each method of capital budgeting that you used?

Use capital budgeting to evaluate investment proposals.

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#### Solution Preview

Please see the attachment. The excel file has the calculations for payback period, NPV and IRR.

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The CEO has given you 3 different large projects he's evaluating to see which might be most beneficial to the company to invest in. These include:

A new labor-saving piece of equipment that cost $400,000 and will reduce labor and quality costs by $75,000/year for 6 years.

A new marketing program, costing $500,000 is expected to increase current sales of

$10,000,000/year by 30% for the next 4 years only. The current contribution margin of

30% will remain in effect even with this sales increase.

Launching a new product will cost $600,000; the product is expected to sell for $15/unit

at a volume of 20,000 units/year for 3 years, at a 40% contribution margin.

The firm's overall cost of capital is 10%.

As a follow up to your capital budgeting analysis, the CEO asked you to write a memo addressing these specific questions:

Why does a firm need to have a capital budgeting process?

A firm needs to have a capital budgeting process, since capital budgets have large outlays and affect the firm for a long period of time. Thus the future of a firm depends on the kind of capital budgeting process that it has. If the capital budgeting process is not good, the firm may not invest in correct projects or invest in wrong projects and the end result would be difficulties in the survival of the firm.

A good capital budgeting process is needed so that the firm is able to correctly identify the opportunities available and make ...

#### Solution Summary

The solution explains some details and calculations relating to the given capital budgeting proposals. The primary methods of capital budgeting is determined.