capital budgeting example questions

Guri Bee

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23-10-2024

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Capital Budgeting: Solving Real-World Investment Decisions with Example Questions

Capital budgeting is the process companies use to evaluate potential long-term investments, typically those with a lifespan of more than one year. These investments could range from purchasing new equipment to building a new factory. Effective capital budgeting helps companies allocate their limited resources wisely, maximizing returns and ensuring long-term financial health.

This article will explore capital budgeting with real-world examples, helping you understand how companies approach these important decisions.

Key Concepts in Capital Budgeting

Before diving into examples, let's understand the key concepts:

• Net Present Value (NPV): This method calculates the present value of future cash flows generated by an investment, subtracting the initial investment cost. A positive NPV suggests the investment is likely to generate more value than it costs, while a negative NPV indicates the opposite.
• Internal Rate of Return (IRR): This metric represents the discount rate at which the NPV of an investment equals zero. In simpler terms, it's the rate of return an investment is expected to generate. A higher IRR usually implies a more desirable investment.
• Payback Period: This is the time it takes for an investment to generate enough cash flow to recover the initial investment. A shorter payback period is generally preferred, indicating a quicker return on investment.
• Profitability Index (PI): The PI measures the ratio of the present value of future cash flows to the initial investment cost. A PI greater than 1 suggests the investment is profitable, while a PI less than 1 suggests it's not.

Example Questions & Solutions

Let's explore some common capital budgeting scenarios and apply these concepts:

Example 1: New Equipment Purchase

Scenario: A company is considering purchasing a new machine for $500,000. The machine is expected to generate an annual cash flow of $150,000 for the next five years. The company's cost of capital is 10%. Should the company invest in the new machine?

Solution:

We can use NPV to evaluate this investment.

Total NPV: $15,450

Conclusion: The NPV is positive, suggesting that the investment is likely to generate a return exceeding the cost of capital. The company should invest in the new machine.

Example 2: Expansion Project

Scenario: A company is considering expanding its operations by building a new factory. The factory will cost $10,000,000 to build and will generate annual cash flows of $2,500,000 for the next 10 years. The company's cost of capital is 8%. Should the company invest in the expansion?

Solution:

We can calculate the IRR to evaluate this investment.

... 10 | $2,500,000

Using a financial calculator or spreadsheet software, we can determine the IRR is approximately 11.45%.

Conclusion: The IRR (11.45%) is higher than the company's cost of capital (8%), suggesting the expansion project is likely to generate a return exceeding the required rate of return. The company should invest in the expansion.

Example 3: Choosing Between Two Investments

Scenario: A company has two investment opportunities:

• Investment A: Initial investment of $1,000,000, expected cash flows of $300,000 annually for 5 years, and a cost of capital of 12%.
• Investment B: Initial investment of $500,000, expected cash flows of $150,000 annually for 5 years, and a cost of capital of 10%.

Which investment should the company choose?

Solution:

We can use the Profitability Index (PI) to compare these two investments.

Investment A:

PI = (PV of Future Cash Flows) / (Initial Investment) PI = ($1,243,362) / ($1,000,000) = 1.24

Investment B:

PI = (PV of Future Cash Flows) / (Initial Investment) PI = ($621,681) / ($500,000) = 1.24

Conclusion: Both investments have a PI greater than 1, indicating they are likely to be profitable. However, Investment A has a higher PI, suggesting it might offer a higher return per dollar invested. The company should likely choose Investment A.

Additional Factors to Consider

While these examples demonstrate the application of key capital budgeting techniques, several other factors can influence investment decisions:

• Qualitative Factors: These include factors that are difficult to quantify, such as market demand, competitor analysis, technological advancements, and potential risks.
• Strategic Alignment: Investments should align with the company's overall business strategy.
• Environmental, Social, and Governance (ESG) Considerations: Companies are increasingly factoring ESG factors into their investment decisions.
• Sensitivity Analysis: This involves analyzing how changes in key variables (like cost of capital, cash flows, or project lifespan) can impact the profitability of an investment.

Final Thoughts

Capital budgeting is a crucial aspect of financial management that helps companies make sound investment decisions. By understanding key concepts like NPV, IRR, payback period, and PI, and considering both quantitative and qualitative factors, companies can make informed decisions that drive long-term growth and profitability.