1. How are project classifications used in the capital budgeting process? 2. wha
ID: 2796801 • Letter: 1
Question
1. How are project classifications used in the capital budgeting process?
2. what are three potential flaws with the reqular payback method? Does the discounted payback method correct all three flaws?Explain.
3. Why is the NPV of relatively long-term project(One for which a high percentage of its cash flows occurs in the distance futurs) more sensitive to changes in the WACC than that of a short-term project?
4. What a mutually exclusive project? How should managers rank mutually exclusive projects?
5. If two mutually exclusive projects were being compared, would a high cost of capital favor the longer-term or the shorter-term project?why? if the cost of capital declined, would that lead firms to invest more in longer-term projects or shorts-term project? Would a decline or an increase in the WACC cause change in the IRR ranking of mutually exclusive project? explain.
Explanation / Answer
1) Capital budgeting process is an important process for the business to identify and evaluate the projects where they should invest their capital and ensure the future success of the firm.
Capital budgeting projects could be of different categories -
i)Replacement projects to maintain business operations or for cost-reduction
ii) Expansion projects to grow business like venturing into a new product or a new market.
iii) Mandatory projects required by governments or the regulatory authorities.
Also, 2 projects can be classified as independent and mutually exclusive projects. For the mutually exclusive projects, decision has to made to select one of the projects or in other words, both the projects cannot go along unlike for independent projects, where the 2 projects are in 2 different spheres individually and need not be analysed together.
2) Flaws of payback method is -
i) Biggest drawback of this method is that it does not consider the time value of money. It treats the cash flow received in the same year of cash outflow to be equivalent to cash flow received 1 or 2 years later while calculating the payback period.
ii) It doesn't look at the profitability by focussing at the cash flows beyond calculated payback period.
In other words, It will treat a project which will give cash infows upto 10 years at par with a project which gives similar cash inflows till 5 years if their payback period although profitability may be much higher for the other.
iii)It considers that the project outflow would be one single outflow which would not be the case always. Usually cash outflows are spread over initial few years.
Discounted payback method addresses one of the issues of regular payback method by using time value of money instead of absolute cash flows. It calculates the present value of cash flows to calculate payback time.
The other issues of ignoring profitability and considering one single outlfow still remains there.
3) NPV of a longer term project would be more sensitive to WACC as we are using discounting the future cash flows with WACC and any changes in discounting rate would effectively change the present value of the cash flows. Basically, present value of cash flows in longer projects are more exposed to discounting rates as compared to short term project.
PV = FV/[(1+r)^n], increase in n (no of years) will magnify any changes in r (WACC here)
4)Mutually exclusive projects means that out of n number of projects, we can only finalise one of the project.Selecting one project rejects other projects.
Net Present Value approach (NPV) approach is one of the approaches used to finalise a project. NPV gives the expected increase in value of the firm. Project providing highest NPV could be selected.
Internal Rate of Return (IRR) approach is another approach that helps to decide the project.
IRR gives the return on each dollar invested. If the IRR of the project is greater than required return (which may be WACC), accept the project.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.