1. Describe capital budgeting?
2. What types of small business decisions require capital bugeting?
3. Name the different capital budgeting decision techniques available to the small business owner.
4. Describe how the Internal Rate of Return method works.
5. What do you think is the reason managers feel most managers feel most comfortable basing capital budget decisions on the IRR method?
1. Describe capital budgeting?
2. What types of small business decisions require capital bugeting?
3. Name the different capital budgeting decision techniques available to the small business owner.
4. Describe how the Internal Rate of Return method works.
5. What do you think is the reason managers feel most managers feel most comfortable basing capital budget decisions on the IRR method?
Related questions
Capital budgeting involves choosing projects that add value to the firm. The net present value (NPV), internal rate of return (IRR) and payback period methods are the most common approaches to project selection. At its core, capital budgeting is measuring an accounting of costs versus benefits. In a way, all business decisions are a series of capital budgeting decisions. Get it wrong, and you can destroy a company.
The capital budgeting tools help financial managers decide on the desirability of the projects. In the real world, however, managers sometimes will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods.
For example, consider the two mutually exclusive projects below.
| Investments | Cost | Cash Flow 1 | Cash Flow 2 |
| Project A | $ 50 | $ - | $ 100 |
| Project B | $ 50 | $ 50 | $ 25 |
According to the payback period, project B should be selected. Although both projects cost the same, project B has a payback period of one period, while project A will payback in roughly 1.5 periods.
Assuming the discount rate of 5%, NPV(A) = $41 and NPV(B) = $20.
This example illustrates the limitations of the payback period method. Even though the payback period method points to project B, the NPV method points to project A since it has more than twice the NPV value to that of project B. Yet the manager may choose project A. Why?
It may be that the project stakeholder is requesting a quicker return in cash.
For this discussion, create an example problem where two (or more) methods contradict each other. What would be the "appropriate" choice (which project would you choose)? In what cases would you not choose the "best" choice?
The conference on evaluating capital projects has been very helpful. You have received a significant amount of information and multiple projects to evaluate to hone your skills. To adequately teach Grammy and the board you will need to answer several questions about the capital-budgeting process. You will do this in a business memo that is no more than four pages long.
Provide an evaluation of two proposed project, both with a 5-year expected lives and identical initial outlays of $110,000. Both of these projects involve additions to a highly successful product line, and as a result, the required rate of return on both projects has been established at 12 percent. The expected free cash flows from each project are as follows:
| Project A | Project B | |
| Initial outlay | -$110,000 | -$110,000 |
| Inflow year 1 | 20,000 | 40,000 |
| Inflow year 2 | 30,000 | 40,000 |
| Inflow year 3 | 40,000 | 40,000 |
| Inflow year 4 | 50,000 | 40,000 |
| Inflow year 5 | 70,000 | 40,000 |
In evaluating these projects, please respond to the following question:
Why is the capital-budgeting process so important?
Why is it difficult to find exceptionally profitable projects?
What is the payback period on each project? If the organization imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?
What are the criticisms of the payback period?
Determine the NPV for each of these projects. Should they be accepted?
Describe the logic behind the NPV.
Determine the PI for each of these projects. Should they be accepted?
Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
What would happen to the NPV and PI for each project if the required rate of return increased? If the required rate of return decreased?
Determine the IRR for each project. Should they be accepted?
How does a change in the required rate of return affect the projectâs internal rate of return?
What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?
