Making a capital budgeting decision is one of the most important policy decision

Question

Making a capital budgeting decision is one of the most important policy decisions that a firm makes. A firm that does not invest in long-term investment projects does not maximize stakeholder wealth. Capital budgeting decisions determine the future of the company. An appropriate investment decision can yield spectacular returns. On the other hand, a misguided and incorrect decision can endanger the very survival of the firm. A few wrong decisions and the firm may be forced into bankruptcy. Capital budgeting decisions generally are either replacement decisions or expansion decisions. Replacement decisions are for purchasing of assets to replace existing assets that might be worn out, damaged or obsolete. Expansion decisions are made to add capital projects to the existing assets so as to produce either more of its existing products or entirely new products. Capital budgeting decisions are deciding which projects a firm should accept and which it should reject. Various capital budgeting techniques may be used to arrive at the most suitable decisions. A company in Dubai is considering investments in the seven projects listed in Exhibit 1. The company is approaching you asking you to rank the projects and recommend the “three best” that the company should accept. To keep it simple, you are required to consider only the quantitative factors for the selection of the projects. That is, no other project characteristics are relevant in the selection, except that management has determined that projects 4 and 5 are mutually exclusive. To guide your analysis, focus on the following questions:

1. Rank the projects simply by inspecting the cash flows (the excess of cash inflows over cash outflows).

2. Rank the projects using various quantitative methods. Assume that all projects are from the same risk class and the appropriate discount rate is 9%. Briefly explain the various methods, and specify which quantitative ranking methods are better and why?

3. Compare the ranking obtained by quantitative methods with the ranking obtained by simple inspection of the cash flows. Do they differ, explain the reasons for this?

4. Recommend the ‘three best’ projects that the company should accept (Project 4 and Project 5 are mutually exclusive).

EXHIBIT1 Project Free Cash Flows (UAE Dirhams in thousands) Proiect number Year 5.000(10,000) (15,000 25.000) (25.000 (30,000) (35,000 1,000 1,000 1,000 800 800 700 600 600 500 500 1,000 1,700 2,000 1,700 2,000 1,700 3,000 1,700 3.000 4,000 1,700 4.000 2,000 1,700 2,000 1,700 2,000 1,7 100011,000 3,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 0011,000 1,20010,00010,000 9,000 8,000 7.000 6,000 5,000 4,000 3,000 5,000 6,000 6,000 8,000 9,000 6,000 6,000 6,00012,000 4.500 12,000 4,50014,000 3,000 14,000 3,00014,000 1,700 1,700 10 Sum of cash-flow benefits (cash inflow Excess of cash inflow over initial investment (cash outflow 7,50025,00017,000 55,200 68,00052,000 86,000 2,50015,000 2,000 30,200 43,00019,000 39.000 1 USD 3.67 AED

Explanation / Answer

Answer (b)

Reason :- The [project giving higher NPV is choosing First then the next and the project giving Negative NPV then reject that project

Answer (d)

The three best projects to invest is project , 5th 3rd and 4th

Answer (a) Project Cash flows year 1 2 3 4 5 6 7 0 -5000 -10000 -15000 -25000 -25000 -30000 -35000 1 1000 1000 1700 1000 11000 -3000 -9000 2 1000 2000 1700 1200 10000 10000 -3000 3 1000 2000 1700 3000 9000 9000 6000 4 800 3000 1700 4000 8000 6000 6000 5 800 3000 1700 5000 7000 6000 8000 6 700 4000 1700 6000 6000 6000 12000 7 600 4000 1700 7000 5000 4500 12000 8 600 2000 1700 8000 4000 4500 14000 9 500 2000 1700 9000 3000 3000 14000 10 500 2000 1700 11000 5000 3000 14000 Sum of Cash inflow benefits 7500 25000 17000 55200 68000 52000 86000 Excess of inflow over outflow 2500 15000 2000 30200 43000 19000 39000 % of return over investment 50% 150% 13% 121% 172% 58% 83% Rank 6 2 7 3 1 5 4

Related Questions

Navigate

• Browse (All)
• Browse M
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.