Capital Budgeting

Capital Budgeting Scenario

Nathan Gorr

FIN/486

June 6, 2011

Temple Moore

Capital Budgeting Scenario

Capital budgeting decisions must be based on the evaluation of an investment proposal’s economic viability. The net present value method of capital budgeting uses discounted cash flows to determine whether or not an investment is acceptable given certain assumptions. This report will analyze a proposal for the purchase of a labor-savings piece of equipment. An explanation of specific calculations, the effects of varying costs of capital, and the use of capital budgeting techniques in strategic financial management will be presented.

Net Present Value Analysis

The proposal to purchase a labor-saving piece of equipment that will last five years assumes the discount rate or weighted average cost of capital is 10%. Since labor content is 12% of $10 million in sales annually, this can be stated as an annual labor cost of $1.2 million ($10,000,000 × 0.12). The new equipment is expected to save 20% of labor annually, resulting in a $240,000 ($1,200,000 × 0.20) reduction in cost each year over the next five years. The cost of the new equipment, or initial investment, is $200,000.

In order to determine if the proposal should be accepted, the annual $240,000 savings of labor costs must be discounted to its present value. Since the present value interest factor for a one-dollar annuity discounted at 10% for five periods is 3.791 (Gitman, 2009, pg. 904), the present value of the labor cost savings can be calculated as $909,840 ($240,000 × 3.791). When the initial investment is subtracted from the present value of cost savings, the resulting $709,840 ($909,840 - $200,000) is the net present value. The net present value method of capital budgeting dictates that a positive net present value represents an acceptable proposal since the actual return will be greater than the cost of capital. Therefore, the proposal to purchase the...