Capital Budgeting Choices
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Some capital-budgeting choices require managers to decide between upgrading high-technology research equipment and not upgrading.
Respond to the following questions:
1. How would financial managers at a drug manufacturing company use discounted-cash-flow models in their decision-making process?
2. If the equipment is not replaced, what would be the impact on future operating cash flows used in the model?
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The solution discusses capital budgeting choices.
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1. The distinguishing characteristic of the discounted cash flow capital budgeting techniques is that they take into consideration time value of money while evaluating the costs and benefits of a project. In one form or other these methods require cash flows to be discounted at a certain rate called the cost of capital. The discount rate used is generally the appropriate Weighted average cost of capital (WACC), that reflects The discount rate reflects two things:
The time value of money (risk-free rate) -investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay.
A risk premium - reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all.
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