Financial Management (Capital Budgeting Mini Case)

FINANCIAL MANAGEMENT: CAPITAL BUDGETING MINI CASE

1

CAPITAL BUDGETING (MINI CASE)

QUESTION A What is capital budgeting?

Solution: Capital budgeting is a required managerial tool. 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. In other words, capital budgeting is the process of analysing additions to fixed assets. Capital budgeting is important because, more than anything else, fixed asset investment decisions chart a company's course for the future. Conceptually, the capital budgeting process is identical to the decision process used by individuals making investment decisions. These steps are involved:

1. Estimate the cash flows--interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects. 2. Assess the riskiness of the cash flows. 3. Determine the appropriate discount rate, based on the riskiness of the cash flows and the general level of interest rates. This is called the project cost of capital in capital budgeting. 4. Evaluate the cash flows.

1|Page

FINANCIAL MANAGEMENT: CAPITAL BUDGETING MINI CASE

2

QUESTION B What is the difference between independent and mutually exclusive projects? Solution: Projects are independent if the cash flows of one are not affected by the acceptance of the other. Conversely, two projects are mutually exclusive if acceptance of one impacts

adversely the cash flows of the other; that is, at most one of two or more such projects may be accepted. Put another way, when projects are mutually exclusive it means that they do the same job. For example, a forklift truck versus a conveyor system