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Capital budgeting could be defined as a process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Most times, a prospective project’s lifetime cash inflow and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. Capital budgeting is also known as investment appraisal. Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. Generally, businesses prefer to intricately study a project before taking it on, as it has a great impact on the organization’s financial performance. Capital budgeting is an essential managerial tool. One important duty of a financial manager is to choose investments with satisfactory cash flows and rates of return.
In essence a financial manager should be able to decide if an investment is worth undertaking and should also have the ability to choose intelligently given other alternatives. Capital budgeting is primarily concerned with sizable investments in long-term assets. These assets can either be tangible items such as property, plant or equipment or intangible ones such as new technology, patents or trademarks. Investments in processes such as research, design and development and testing – through which new technology and new products are created may also be viewed as investments in tangible assets.
Capital budgeting is the process that companies use for decision making on capital projects-those projects with a life of a year or more. This is a fundamental area of knowledge for financial analysts for many reasons. The main perspective of this assignment is to analyze a project from different methods available of capital budgeting. There are two main questions which require being answer in this particular assignment.
Overview of the company and the project
The company which has been chosen for this project is a hypothetical one with the name of A;-Sharif Shipping. The Al-Sharif Shipping Company is a family operation owned by the three Al-Sharif brothers. Mohamed Ibrahim, the son-in-law of the oldest Al-Sharif brother, has taken over as assistant manager of the firm, with specific responsibilities for evaluating capital investment projects. The description of the projects including cost and cash flows are mentioned below,
Cost of capital which would have been used are 10% and 14%.
Ans-1) Net Present Value of the Projects
A dollar earns today is more worthwhile if it is earn after a few years. Net Present Value (NPV) as define by name it is the future value in terms of present. It is the most widely used measure in investment appraisal that likes by almost all the financial managers because of its propensity to appraise the actuality of the project (Leopard & Bernstein, 1999). NPV is a vital tool in discounted coins flow (DCF) analysis, and is a model sense for with the time cherish of money to appraise long-time projects. Used for capital budgeting, and commonly throughout economics, finance, and accounting, it events the overkill or loss of notes flows, in state value terms, once financing charges are met. The discount rate used in the NPV analysis is the weighted average cost of capital (WACC) of the company which is so essential (Borodovsky & Gogarten, 2010).
a) Computational table of each project has been mentioned below,
|Project||A||Cost of Capital %||Cost of Capital %||B||Cost of Capital %||Cost of Capital %|
|Sum of Cash Flows||282,645||258,374||921,685||782,417|
|Less: Initial Outlay||240,000||240,000||800,000||800,000|
|Project||C||Cost of Capital %||Cost of Capital %||D||Cost of Capital %||Cost of Capital %|
|Sum of Cash Flows||122,891||104,322||139,744.6||132,942.4|
|Less: Initial Outlay||113,000||113,000||120,000||120,000|
|Project||E||Cost of Capital %||Cost of Capital %||F||Cost of Capital %||Cost of Capital %|
|Sum of Cash Flows||107,881.98||100,808.30||280,788.64||242,794.53|
|Less: Initial Outlay||100,000.00||100,000.00||200,000.00||200,000.00|
Internal rate of return is also one of the most famous tools of Investment appraisal used by the managers. It is based on company’s WACC (Borodovsky & Gogarten, 2010). The internal rate of return (IRR) is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a certain project equal to zero. This in essence means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project (or investment) equals its current market value.