Scribd
Upload
6 views

Written Assignment Unit2

The document discusses capital budgeting as a method for selecting long-term asset investments, emphasizing the importance of assessing risks and potential returns. A case study is presented where two partners evaluate the purchase of new equipment using the net present value (NPV) method, leading to differing conclusions on the project's viability based on projected cash inflows. Ultimately, the analysis highlights the significance of understanding financing costs and the impact of economic fluctuations on capital investment decisions.

Uploaded by

Mitchell Jarrett
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
6 views

Written Assignment Unit2

The document discusses capital budgeting as a method for selecting long-term asset investments, emphasizing the importance of assessing risks and potential returns. A case study is presented where two partners evaluate the purchase of new equipment using the net present value (NPV) method, leading to differing conclusions on the project's viability based on projected cash inflows. Ultimately, the analysis highlights the significance of understanding financing costs and the impact of economic fluctuations on capital investment decisions.

Uploaded by

Mitchell Jarrett
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 3

Written Assignment

Introduction

Pradeepa (2020) defines capital budgeting as a method for choosing long-term asset investments and
whether to proceed with a particular project in light of the possibility that certain investment options
won't work out. Therefore, managers will assess the quantitative and qualitative risks as well as the profit
of initiatives in order to select those that have a higher return rate than the cost of funding them.

A CASE STUDY

My partner and I are preparing to buy new equipment because we think it will help our business
develop dramatically. We are also presently considering our options for adding a new product to our
range of offerings. The project is a big step forward in the expansion of our company, WePROMOTE,
because it will bring in cash inflows for many years.

However, our organization will need to make a large financial commitment in order to begin this project.
Since the planning is still in its early phases, all of the statistics and other data are approximations.
Despite these approximations, we needed to make sure the project was lucrative, so as you will see in a
moment, we dug into some actual arithmetic.

According to Heisinger & Hoyle (n.d.), the net present value (NPV) technique is used to analyze long-
term investments. It entails summing the present value of all cash inflows and deducting the present value
of all cash outflows. If the NPV value of the option is more than or equal to zero, it can be accepted; if
not, it will be refused. The following formulas are used to compute Net Present Value (NPV), per Analyst
Prep (2020):

FORMULA (1) NPV=∑ t=1 n EEt (1+r)t –Outlay

Where

EEt = expected earnings at time t

t = time or number of time cycles

r = the necessary rate of return on investment

Outlay Outlay= Initial Investment Cash flow

Option (A) My Partner’s View: According to my partner, we ought to:

 Use our own funds to pay for the project.

 Before the initiative begins to generate any revenue, the $80,000 cost of the equipment
will be incurred.
 The following seven years will bring in $14,000 for the firm annually.

 After seven years, the machinery will no longer function and may be worth $5,000 if
salvaged.

 The cost of credit, or discount rate, will be 7%, with the possibility of future increases.

When formula (1) is applied to this option (A), the NPV (I) will be negative in the following
way:

NPV(I)= 14,000 + 14,000 + 14,000 + 14,000 + 14,000 + 14,000 + 14,000 −80,000


(1+0.07)1 (1+0.07)2 (1+0.07)3 (1+0.07) (1+0.07)5 (1+0.07)6 (1+0.07)7

NPV (I) =−1,436

Because of its negative net present value (NPV), this option has no profit or return and should be refused.

Option (B): My Thoughts

All of my partner's assumptions in this option are accurate, with the exception of point (3), where I
predict cash inflows of $14,000 in the first year, $16,000 in years 2-4, and $17,000 in years 5-7. We may
obtain a positive NPV (II) by using this in conjunction with formula (1) above.

NPV (I) =14,000 + 16,000 + 16,000 + 16,000 + 17,000 + 17,000 + 17,000 −80,000
(1+0.07)1 (1+0.07)2 (1+0.07)3 (1+0.07)4 (1+0.07)5 (1+0.07)6 (1+0.07)7

NPV (II) =+9,475

Because of this, this option has a positive net present value (NPV), indicating that it will provide a profit
and may be taken.

My partner was still unconvinced, though, even after the computations shown above. Upon elucidating
the rationale behind our NPV computations, which involved aggregating the cash flows to see if the
outflows of cash exceed the inflows, indicating a positive return on the investment, he expressed his
satisfaction and decided to move on with the venture.

Due to the time value of money, which is correlated with our discount rate of 7%, investors should be
aware that each cash flow has a present value because they happen over a period of seven years.
Therefore, in order to total the cash inflows and outflows, each cash flow needs to be discounted to a
common point in time.

Final Summary

Within the financial community, using equity to finance capital investment projects is considered
extremely costly. Seeking the maximum profit at the lowest cost in the shortest amount of time is in
opposition to the fundamental financial management principle, which aims to maximize shareholder
value. When analyzing long-term capital investment projects, businesses use the net present value (NPV)
method. Its early estimates may thus be off because of this, as its worth is likely to fluctuate in reaction to
changes in the economy.

But it's important to understand that using a combination of debt and equity is less expensive, and that the
cost of capital for individual firms as well as the financial combination can fluctuate significantly at any
time throughout normal economic cycles, even within the same industry. There are riskier firms than
others. It is possible for distinct capital structures to arise in various enterprises, either intentionally or
accidentally.

References

Timelines – Your best friends (Calculations for CFA® and FRM® exams) . (2020, December 31).
AnalystPrep. https://analystprep.com/blog/timelines-your-best-friends-calculations-for-cfa- and-frm-
exams/

Pradeepa, H. (2020, April 28). Capital budgeting: Meaning, process and techniques. QuickBooks.
https://quickbooks.intuit.com/in/resources/budget/capital-budgeting/

Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers.


https://2012books.lardbucket.org/books/accounting-for-managers/index.html

You might also like