Key Concept Exercise
Capital budgeting
This week you will consider the usefulness of the different types of investment appraisal techniques and you also have the opportunity to perform some introductory calculations to confirm your appreciation of the underlying concepts behind each method. Many organizations use multiple investment appraisal techniques in order to evaluate whether an investment should be undertaken. It is also equally important to consider the qualitative aspects of an investment in addition to the quantitative aspects. For example, many qualitative aspects including ethical and environmental considerations can affect the viability of any investment decision and can influence the outcome of the same.
To prepare for this Key Concept Exercise:
Read the Required Learning Resources for Week 6.
Part A
For the following exercise, complete the calculations below. Evaluate different capital investment appraisal techniques by completing the calculations shown below:
Bongo Ltd. is considering the selection of one of two mutually exclusive projects. Both would involve purchasing machinery with an estimated useful life of 5 years.
Project 1 would generate annual cash flows (receipts less payments) of £200,000; the machinery would cost £556,000 with a scrap value of £56,000.
Project 2 would generate cash flows of £500,000 per annum; the machinery would cost £1,616,000 with a scrap value of £301,000.
Bongo uses straight-line depreciation. Its cost of capital is 15% per annum.
Assume that all cash flows arise on the anniversaries of the initial outlay, that there are no price changes over the project lives, and that accepting either project will have no impact on working capital requirements.
Assess the choice using the following methods by completing the calculations shown below:
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Cash flows
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200
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Less: depreciation (see below)
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100
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Accounting profits
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100
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• ARR
• NPV
• IRR
• Payback period
Calculate the missing answers:
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Project 1
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Project 2
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|
ARR (see workings)
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33%
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???
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|
NPV (£'000)
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???
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210
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|
IRR
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25%
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???
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|
Payback Period (yrs)
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???
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3.2
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ARR workings (Project 1)
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Cash flows
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200
|
|
Less: depreciation (see below)
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100
|
|
Accounting profits
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100
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These profits are the same each year in this question.
Annual depreciation (Cost - SV) / 5
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(556,000 - 56,000) / 5
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100
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Average NBV of investments
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(556 + 56) /2
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306
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ARR
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33%
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Be sure to demonstrate your workings.
Part B
In formulating your Key Concept Exercise, consider the following question:
What are some of the alternative methods of investment appraisal?
In an approximately 500-word response, address the following issues/questions:
Many businesses around the world still fail because their capital investment decisions are based upon a calculation on the back of an envelope and do not take any of the correct factors into account. Even larger businesses often get this wrong. This is a true sign of poor resource management.
Do you agree or disagree? Discuss the alternative methods of investment appraisal and describe the limitations of these to help justify your arguments. How do you think that capital budgeting decisions should ideally be made by different types of organisations?