Basics of Capital Budgeting Assignment

Basics of Capital Budgeting Assignment
Chapter 9. The Cost of Capital
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Chapter 10. The Basics of Capital Budgeting: Evaluating Cash Flows
Basics of Capital Budgeting Assignment
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Finance – Week 5 Lecture
Cost of Capital and Capital Budgeting
Capital projects can be a lot of fun and a lot of work. A capital project is generally a project that requires a significant investment into something that will last a significant amount of time. For example, assume we are running our own small town bakery and wanted to invest in some new aprons. The aprons are low cost and will last only a few months before they are stained or worn and will need to be replaced. This is not a capital project for our bakery. We also would like to invest in a new, larger oven that will allow us to produce more baked goods daily and hopefully increase our sales. The oven requires a large investment and is expected to have a useful life of ten years or more. The oven is a great example of a capital project!
Now we have to figure out if our oven is worth the investment! Most organizations have a wish list of projects they would like to invest in that is a mile long. The funds they have available to spend on their projects, however, is not a mile long. Therefore they must assess each project and decide in which projects to invest.
Many methods are available to help us assess the possibility of investing in our new oven. The net present value method takes into the consideration the present value of all the future cash flows our oven might produce for us then compares that amount to how much we have to invest in our oven today. If the result is positive we would likely approve the project and get our oven. If the result is negative that means that the investment we make today is greater than the present value of all the funds we hope to gain from the project. Thus, we would reject the project and not get our new oven.
Basics of Capital Budgeting Assignment
We could also choose to use the internal rate of return calculation to assess our oven project. The internal rate of return reflects the amount of return we could possible earn on our project given the rate at which our firm must borrow capital. If the internal rate of return is higher than our firms cost of capital (how much it costs us to use or borrow funds) then we would likely accept the project. If the internal rate of return is lower than our cost of capital that means our oven would be earning us less than what it costs us to borrow money. If that is the case we would likely reject the project.
It’s key to note that both the net present value and internal rate of return take into consideration the time value of money. In an earlier lecture we talked about the basic concepts of the time value of money and learned that it costs money to use money. If we use debt to fund our projects we will have to pay interest. If we use equity to fund our investments we will have to pay dividends. If we use our own idle cash we have to earn more on our project than we could have earned on other investments. No matter what source of funds we use, we have to ensure that our project is earning more than the funds are costing us.
Another popular method of assessing projects is the payback method. Unlike net present value and internal rate of return, the payback method is quite basic and does not take the time value of money into consideration. The payback method reflects how many periods it takes to recoup our initial investment. This helps management understand how long their funds will be tied up in the project before they come back in the form of higher sales or lower costs. While the payback method is helpful, it doesn’t take into consideration the time value of money nor does it give any indication of how profitable the project is after it reaches the point of payback.
Now that we know some of the basic assessment methods we could do some calculations to help us determine if our oven is a good investment or not and whether or not it’s a better investment than other projects we would like to do on our limited capital budget. It’s key to note that while the assessment methods are very helpful, there are other items that should be considered as well. Employee and customer safety is a key concern. For example, if our current oven were malfunctioning and posed a hazard to our employees, we may still want to invest in the new oven even if the calculations we perform show that the oven doesn’t provide a high return. The calculations used to assess capital projects are a great starting point but should be used in conjunction with other elements that are important to the organization such as long term strategy and customer and employee safety and satisfaction.
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