Part I:
One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.
Virtually all general managers face capital-budgeting decisions in the course of their careers. The most common of these is the simple "yes" versus "no" choice about a capital investment. Regardless of the type of project, however, certain principles of capital budgeting should always be considered. The most important of these principles are:
- Focus on cash flows, not profits.
- Focus on incremental cash flows.
- Account for time.
- Account for risk.
Write an essay discussing the meaning and importance of each of these principles as they apply to capital budgeting. Evaluate the importance of each principle and discuss the consequences of ignoring any of these principles.
You must use a minimum of 3 scholarly sources to support your discussion.
Part II:
A private school is considering the purchase of six school buses to transport students to and from school events. The initial cost of the buses is $600,000. The life of each bus is estimated to be five years, after which time the vehicles would have to be scrapped with no salvage value. The school's management team has derived the following estimates for annual revenues and cost for the next five years.
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Year 1
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Year 2
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Year 3
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Year 4
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Year 5
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Revenues
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$330,000
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$330,000
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$350,000
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$380,000
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$400,000
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Driver costs
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$33,000
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$35,000
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$36,000
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$38,000
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$40,000
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Repairs & maintenance
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$8,000
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$13,000
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$15,000
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$16,000
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$18,000
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Other costs
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$130,000
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$135,000
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$140,000
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$136,000
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$142,000
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Annual depreciation
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$120,000
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$120,000
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$120,000
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$120,000
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$120,000
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The buses would be purchased at the beginning of the project (i.e., in Year 0) and all revenues and expenditures shown in the table above would be incurred at the end of each relevant year.
Because schools are exempt from taxes, the school's corporate tax rate is 0 percent. A business consultant has advised management that they should use a weighted average cost of capital (WACC) of 10.5 percent to evaluate this project.
- Prepare a table showing the estimated net cash flows for each year of the project. Explain all steps involved in your calculation of the Year 1 estimated net cash flow.
- Calculate the project's Payback Period. Explain in your own words, all steps involved in the calculation process.
- Calculate the project's Internal Rate of Return (IRR). Explain in your own words, all steps involved in the calculation process.
- Calculate the project's Net Present Value (NPV). Explain in your own words, all steps involved in the calculation process.
Which is the three evaluation techniques that you computed (i.e., payback period, IRR and NPV), should the firm use to make its decision of whether or not to accept this project? Why? Is one of these techniques better than the others and if so, why?
Finally, what are some risk factors inherent in this capital budgeting analysis? That is, make a list of at least three items that could cause the outcome of this project to be substantially worse than management currently expects (as reflected in their revenue and cost estimates, WACC estimate, etc.). Fully explain each of the risk factors you identify.