Concepts of Capital Budgeting
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1) Define and discuss the following:
a) Required Investments
b) Replacement Investments
c) Expansion Investments
d) Diversification Investments
e) How do these differences impact the allocation of capital funds?
2) When applying the NPV rule, how would increased risk be reflected in the computations?
3) Two projects have the expected cash flows shown below. The projects have similar risk characteristics and their cost of capital is 15 percent.
End of Year Project A Project B
Now (11,000,000) (7,000,000)
1 7,000,000 3,000,000
2 3,000,000 1,500,000
3 3,500,000 1,500,000
4 3,000,000 500,000
a) Calculate the NPV for each project. Which project should be accepted if they are independent? If they are mutually exclusive?
4) Discuss how management determines which projects to fund when there is a limit on the total capital available for investment..
5) How do managers make a choice between investments with unequal life spans?
Please convert the attached from one form to a managerial balance sheet form.
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Solution Summary
This explains the various concept of capital budgeting like NPV, IRR, Project, Risk analysis, Replacement, certainty?equivalent
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3) Two projects have the expected cash flows shown below. The projects have similar risk characteristics and their cost of capital is 15 percent.
End of Year Project A Project B
Now (11,000,000) (7,000,000)
1 7,000,000 3,000,000
2 3,000,000 1,500,000
3 3,500,000 1,500,000
4 3,000,000 500,000
a) Calculate the NPV for each project. Which project should be accepted if they are independent? If they are mutually exclusive?
End of year PROJECT A PROJECT B
Now -11000000 -7000000
1 7000000 3000000
2 3000000 1500000
3 3500000 1500000
4 3000000 500000
Cost of capital 15%
NPV ($343,305.66) ($2,270,814.50)
No project should be accepted as they are giving negative NPV if they are independent.
If mutually exclusive also no project as it is not satisfying the positive NPV criteria.
1) Define and discuss the following:
a) Required Investments
The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.
The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.
Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development program has long-term implications for the firm's expenditures and benefits, and therefore, they should also be evaluated as investment decisions.
Required investment will involve total capital outlay in the project. It will investment in capital expenditure, incremental working capital.
b) Replacement Investments
This type of decision involves replacement of existing machinery/project with new machinery. Here incremental analysis is done.
c) Expansion Investments
This type of decision involves Greenfield or brown field expansion of existing product. It may involve increase in the existing capacity in the same or similar industry in which the company is operating.
d) Diversification Investments
This type of decision involves expanding in the unrelated industry in which the company is currently not operating.
e) How do these differences impact the allocation of capital funds?
All these decisions will involve the cash outflows and operating cash inflows. Thus appropriate capital budgeting technique will be used to evaluate these decisions.
FOR ANALYSING ANY PROJEC EVALUATION CRITERIA:
ESTIMATION OF CASH FLOWS
ESTIMATION OF REQUIRED RATE OF RETURN (THE opportunity cost of capital)
APPLICATION OF DECISION RULE FOR MAKING THE CHOICE
2) When applying the NPV rule, how ...
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