...CAPITAL BUDGETING PROBLEMS: CHAPTER 10 Answers to Warm-Up Exercises E10-1. Answer: Payback period The payback period for Project Hydrogen is 4.29 years. The payback period for Project Helium is 5.75 years. Both projects are acceptable because their payback periods are less than Elysian Fields’ maximum payback period criterion of 6 years. NPV E10-2. Answer: Year 1 2 3 4 5 Cash Inflow $400,000 375,000 300,000 350,000 200,000 Total $1,389,677.35 Present Value $ 377,358.49 333,748.67 251,885.78 277,232.78 149,451.63 $1,389,677.35 NPV $1,250,000 $139,677.35 Herky Foods should acquire the new wrapping machine. CAPITAL BUDGETING PROBLEMS: CHAPTER 10 E10-3: Answer: NPV comparison of two projects Project Kelvin Present value of expenses Present value of cash inflows PV) NPV –$45,000 51,542 (PMT $20,000, N $ 6,542 3, I 8, Solve for Project Thompson Present value of expenses $275,000 Present value of cash inflows 277,373 (PMT $60,000, N 6, I 8, Solve for PV) NPV $ 2,373 Based on NPV analysis, Axis Corporation should choose an overhaul of the existing system. E10-4: Answer: IRR You may use a financial calculator to determine the IRR of each project. Choose the project with the higher IRR. Project T-Shirt PV 15,000, N Solve for I IRR 39.08% 4, PMT 8,000 Project Board Shorts PV 25,000, N 5, PMT 12,000 Solve for I IRR 38.62% Based on IRR analysis, Billabong Tech should choose project T-Shirt. E10-5: Answer: NPV Note: The IRR for Project Terra...
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...CAPITAL BUDGETING: ADVANTAGES AND LIMITATIONS. SEPTEMBER 2012 CHAPTER ONE INTRODUCTION 1.0 Background Study Capital budgeting is the process by which firms determine how to invest their capital. Included in this process are the decisions to invest in new projects, reassess the amount of capital already invested in existing projects, allocate and ration capital across divisions, and acquire other firms. In essence, the capital budgeting process defines the set and size of a firm’s real assets, which in turn generate the cash flows that ultimately determine its profitability, value and viability. In principle, a firm’s decision to invest in a new project should be made according to whether the project increases the wealth of the firm’s shareholders. For example, the Net Present Value (NPV) rule specifies an objective process by which firms can assess the value that new capital investments are expected to create. As Graham and Harvey (2001) document this rule has steadily gained in popularity since Dean (1951) formally introduced it, but its widespread use has not eliminated the human element in capital budgeting. Because the estimation of a project’s future cash flows and the rate at which they should be discounted is still a relatively subjective process, the behavioural traits of managers still affect this process. Capital budgeting is a process...
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...CHAPTER ONE Introduction Understanding and being able to use capital budgeting techniques and investment appraisal tools is usually a standard requirement for most business degrees. In addition learning such methods will also give one an advantage in a real business situation, in which there is the consideration of significant capital expenditure project. Capital budgeting assists management decisions making on the process of ensuring growth of the organization. The techniques are divided into two types: one, Traditional (non-discounting) that includes pay back method, accounting rate of return (ARR). Two, discounting cash flow that includes net present value (NPV), internal rate of return (IRR) Profitability Index (PI). Before an investment appraisal is conducted, there are a number of points to keep in mind. Whilst the tool presented will give an evaluation of the worth of a project, one should consider that the answer is only a guide. In short, the results of an investment appraisal should be considered in conjunction with both common sense and other qualitative factors such as a business’s overall strategy. Secondly, before an investment appraisal is conducted, one should consider whether or not the project is mutually exclusive. Where a project is mutually exclusive, then only the best project should be selected. Where on the other hand, projects are independent; one may select all projects which give the appropriate return. 1.1 Background of the study Corporate finance...
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...Name: Professor’s name: Dr. Wright Course: AF 211 Accounting for Planning and Control Managers in making investment decisions are faced with the problem of limited resources. This, therefore, necessitates an understanding of the topic of capital budgeting. Capital budgeting is the process of determining and pursuing investments which cash flows are expected in the future period usually more than a year. It entails the decision on the acquisition of new assets or equipment that is to be utilized by the business to increase its future cash flows and profitability. Managers are, therefore, faced with the challenge of determining which project to invest in order to avert the adverse effect on the financial performance. In making investment decisions, various factors must be considered. Managers have to know that the success of the business entirely depends on how best the investments are analyzed before they are undertaken. First, capital budgeting requires large capital outlay (Dugdale 16). Most of the capital budgeting decisions require a large proportion of business funds. It, thus, implies that failure to make proper investment decisions will lead to losses for the organization. Secondly, investment decisions are irreversible. After deciding on what projects to invest in, managers will lack the ability to reverse their decisions, i.e., equipment once acquired cannot be easily disposed of. The managers must therefore be careful before settling on a particular investment...
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...Management J. Volume 2 No. 1 (January 1989) ,' CAPITAL BUDGETING PRACTICES OF INDIAN COMPANIES I. M. PANDEY ' Objective " The objectives of this study are: (a) to document the capital bud geting policies and practices of companies in India, a developing country, and contrast them with those of USA and UK, the developed countries, and (b) to ascertain how business executives look upon the linkage between corporate strategy and investment decision-making. Capital expenditure planning and control is a process of facilitating decisions covering expenditures on long-term assets. Since a company's survival and profitability hinges on capital expenditures, specially the major ones, the importance of the capital budgeting process cannot be over-emphasized. Sample and Methodology We have followed an intensive interview-cum-questionnaire method. Two questionnaires—one dealing with investment evaluation practice and second with other phases—were sent to companies which had agreed to participate in the study. In all, 14 companies were studied. The responding companies belonged to different businesses. In terms of size (sales and number of employees), capital intensity (net tangible fixed assets), volume of spending (capital expenditure incurred), and level of technology, they represent a variety (Table 1). The study relates to 1984. •-, Capital Expenditure: How Defined Strictly speaking, capital expenditure includes all those expenditures which are expected to produce...
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...Stryker Corporation is a medical company founded in 1946 by Homer Stryker. It specializes in medical technology and it is headquartered in Kalamazoo, Michigan. This report will be focused Stryker Corporation’s capital budgeting process and identifying some of the strengths and weaknesses that come along with it. The missions of CERs and the capital budgeting at Stryker: Stryker Corporation has had an outstanding growing background since it started. They have a benchmark of 20% growth annually, and one of the reasons the firm has been able to do this is their way of managing their capital budgeting process. Stryker used CERs (Capital Expenditure Requests) in their capital allocation process. These were basically permission forms that were submitted to be filled out by the authorities in order to get allowance to spend a certain amount of money. The mission of the CERs and the capital budgeting process at striker is to standardize and formalize the capital budgeting process. The CERs made it easier for the company to keep track of the expenditures that were made in each division. Thus, the firm was able to support cash flow targets and maintain the 20% growth of the company. The CERs have been shaped by elements of corporate finance theory. The fact that the CERs are made to have a smarter way of managing the expenditures of the company, automatically refers to the principal goal of corporate finance which is to maximize shareholder’s wealth. Since the CERs are helping...
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...Risk Management in Capital Budgeting Process Introduction: Capital investment decision, like the capital budgeting process, includes series of analysis and decision making processes that have long term impact on the company. Any investment conducted for future net cash growth by company’s management, regardless of investing in intangible or tangible assets can be described as capital budgeting. Company management has obligations towards company owners to increase company wealth. Risk has been recognized as an important component in the capital budget decision making. The future is uncertain and investments techniques that fail to recognize this fact will almost certainly lead to incorrect conclusions and erroneous recommendations. In today’s uncertain and unpredictable global market, where technical, technological and economic development speed is rapidly increasing, selection of optimal process and selection of optimal project is significantly difficult. In many respects, capital budgeting defines an organization’s leadership. Capital budgeting decisions establish strategic priorities, allocate managers to assemble and communicate information across traditional organizational boundaries, for example, marketing, engineering, production, and accounting. The information is evaluated within a rational cost/benefit decision framework by analyzing cash inflows and outflows over time. In project selection process, corporate manager uses various criteria and methods in selecting...
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...Part A “Capital budgeting over the years has become a sophisticated process for the finance officer. The different methods available to the finance officer have increased and become more accurate and centred upon the goal of maximizing wealth. However has there been an increase in the usage of these new methods or are decision makers still using the easier methods?” Capital budgeting is a tool management use to make investment decisions. Despite the pitfalls pointed out in Yee-Ching Lilian Chan’s article “Use of capital budgeting techniques and an analytic approach to capital investment decisions in Canadian Municipal Governments”, which includes overemphasis on the quantifiable aspects of capital projects, random cut offs on the timing and the amount of cash flows, Unrealistic discount rates or IRR assumptions. Methods such as profitability index, internal rate of return, breakeven, payback period and net present value are all discounted cash flows which are commonly used in practice. In 2001 Elijelly, A & Abuldris published an article “ A survey of capital budgeting techniques in the public and private sectors of a less developed country, Sudan” They concluded that most public enterprises in less developed countries, do not apply any capital budgeting methods when making investment decisions. The payback method was the most widely used followed by the Internal rate of return in the private and public sectors that did use capital budgeting techniques. “In contrast to the...
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...Capital Budgeting Techniques | | GLOSSARY Capital Budget: (1) The amount of money set aside for the purchase of fixed assets (e.g., equipment, buildings, etc.). Also, (2) a request for authorization to purchase new fixed assets. Mutually Exclusive Proposals: Consideration of two or more assets that perform the same function. If one is chosen for purchase, the others are automatically rejected. Profitability Index: A ratio of the present value of the benefits (PVB) to the present value of the costs (PVC). The index is used instead of Net Present Value (i.e., PVB - PVC) when evaluating mutually exclusive proposals that have different costs. As the picture above illustrates, the capital budgeting decision may be thought of as a cost-benefit analysis. We are asking a very simple question: "If I purchase this fixed asset, will the benefits to the company be greater than the cost of the asset?" In essence, we are placing the cash inflows and outflows on a scale (similar to the one above) to see which is greater. A complicating factor is that the inflows and outflows may not be comparable: cash outflows (costs) are typically concentrated at the time of the purchase, while cash inflows (benefits) may be spread over many years. The time value of money principle states that dollars today are not the same as dollars in the future (because we would all prefer possessing dollars today to receiving the same amount of dollars in the future). Therefore, before we can place...
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...1 HOTEL OWNER / OPERATOR STRUCTURES: IMPLICATIONS FOR CAPITAL BUDGETING PROCESS Chris GUILDING Service Industry Research Centre, and School of Accounting and Finance Griffith University – Gold Coast Campus Queensland AUSTRALIA C.Guilding@griffith.edu.au Tel: (07) 5552 8790 Fax: (07) 5552 8068 I am grateful for funding support for this study provided by the Australian Cooperative Research Centre for Sustainable Tourism. I would also like to acknowledge the helpful comments and suggestions provided by two anonymous referees. 23 HOTEL OWNER / OPERATOR STRUCTURES: IMPLICATIONS FOR CAPITAL BUDGETING PROCESS ABSTRACT The findings of a field study concerned with appraising capital budgeting process implications arising from different owner / operator structures employed in the hotel industry are reported. Dimensions of conflict that can arise between hotel operators and owners are examined. Consistent with expectations motivated by agency theory, data collected suggest that capital budgeting systems in hotels operating under a divorced owner / operator structure exhibit more formalisation and a greater propensity for investment proposal cash forecast biasing. These findings suggest a degree of dysfunctionalism associated with the divorced / owner operator structure widely adopted in the hotel industry. Key words: Hotel, Capital Budgeting, Ownership structure, Agency theory.4 ...
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...shorter life favoured at the expense of longer life projects, which are more illiquid. Under UWA Plastic criterion the project must recover the initial investment within six years. The ITF project has a payback period of 3.6 years meaning the project would be accepted. However, the payback method may not provide a reliable decision as it ignores the time value of money and also ignores all cash flows that occur after the payback period relies on an ad hoc decision. Therefore, with respect to the three other criteria’s the payback period, should hold the smallest weight when deciding whether to invest in the ITF project. This is exemplified by the decline in the number of CFO’s using the payback method as their primary method of capital budgeting. The DCF uses the incremental earnings of the project to forecast the cash flows of the project. In doing so...
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...Handouts for Corporate Finance 1 Capital Budgeting Introduction A logical prerequisite to the analysis of investment opportunities is the creation of investment opportunities. Unlike the field of investments, where the analyst more or less takes the investment opportunity set as a given, the field of capital budgeting relies on the work of people in the areas of industrial engineering, research and development, and management information systems (among others) for the creation of investment opportunities. As such, it is important to suggest that students keep in mind the importance of creativity in this area, as well as the importance of analytical techniques. Because a project is financially sound, it must be ethically sound, right? Well . . . the question of ethical appropriateness is less frequently discussed in the context of capital budgeting than that of financial appropriateness. Consider the following simple example: The American Association of Colleges and Universities estimates that 10 percent of all college students cheat at some time during their postsecondary education careers. You might pose the ethical question of whether it would be proper for a publishing company to offer a new book How to Cheat: A User's Guide. The company has a cost of capital of 8% and estimates it could sell 10,000 volumes by the end of year one and 5,000 volumes in each of the following two years. The immediate printing costs for the 20,000 volumes would be $20,000. The...
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...Capital Budgeting Processes and Techniques Keith A. Rossmiller Business 657 Instructor Maxwell September 3, 2012 Capital Budgeting 2 Capital Budget Processes and Techniques Investment decisions impact the long-term success or failure of a company. The capital budgeting theory assumes that the primary goal of a firm’s shareholders is to maximize firm value. The process of analyzing and prioritizing investment opportunities is capital budgeting. Capital budgeting involves three basic steps of identifying potential investments, analyzing the set of investment opportunities that will create shareholder value, and implementing and monitoring the investment projects that a firm should undertake. Managers need analytical tools to help them make the best investment decisions for their firm. This paper will explore six different methods of evaluating investment projects and their advantages and disadvantages. The six methods are the payback period, discounted payback period, net present value, profitability index, internal rate of return, and modified internal rate of return, which method is most used in business, and issues related to capital budgeting. Capital Budgeting 3 Payback Period The first...
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...Guillermo Furniture Store Analysis FIN571 October 22,2012 Portia Boyd Abstract This paper will define and discuss the different alternatives available to Guillermo Furniture Store. I will include a sensitive analysis; the optimal weighted averages cost of capital, discuss the use of multiple valuation techniques in reducing risks and calculate the net present value of future cash flows for each of the alternatives. Guillermo Navallez was owner of Guillermo Furniture Store located in Sonora Mexico. Guillermo Furniture Store has been manufacturing handcrafted tables and chairs for a number of years. The company was operating at a profit due to inexpensive labor costs and “the area had a good supply of timber” (University of Phoenix, 2012, para. 1) to produce the handcrafted furniture. The company was prospering without any worries. In 1990, the market shifted and Guillermo began facing challenges in the businessdue to two main factors. One was an overseas furniture business moving into the area. This ompeting company uses high tech methods to produce their furniture to “exact specification” (University of Phoenix, 2012 para 2) at reasonable prices. This was unlike Guillermo’s prices which are a little higher due to their handcrafted technique. This meant the new company could produce furniture faster and cheaper than Guillermo’s company The second factor was the awakening of the laid back relaxed atmosphere in the Sonara community. This was due to the result...
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...Name: Billy (Management International Class 2013) Subject: Business Research method Student Number: B1024131009 Title: Capital Structure Effect on Indofood Financial Performance Problem Formulations: * How Indofood manages their Capital structure with their low cost carrier? * What are the Strategic Investment that the Indofood Company? * How was the Capital Flow of Indofood Company? * How was the Capital Structure affect the Performance and the profitability of Indofood? No. | Name of Researcher (Year of Research) | Tittle | Problem/aim of research | Methodology | Results | Company/Product | 1. | Sven-Olov Daunfeldt and Fredrik Hartwig, 2008. | What Determines the Use of Capital Budgeting Methods? Evidence from Swedish listed companies | Many methods can be used for Capital Budgeting that will affect the other variable such as leverage, etc. | Questionnaire was sent in 2005 and 2008 to the CFOs of all Swedish companies listed on the Stockholm Stock Exchange. From that we can conclude what determine it. | The total use of capital budgeting methods is lower in Swedish companies compared to U.S. and continental European companies | Companies listed on the Stockholm Stock Exchange | 2 | Patricia A. Ryan and Glenn P. Ryan, 2002. | Capital Budgeting Practices of the Fortune 1000:How Have Things Changed? | Prior studies spanning the past four decades show financial managers prefermethods such as internal rate of return or non-discounted payback models over netpresent...
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