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Capital Budgeting Scenarios Paper

573 words - 3 pages

Capital Budgeting Scenarios Paper

Megan Bailey

FIN/486

3/21/2016
Beverley Loyd

Capital Budgeting Scenarios Paper
The selected proposal to purchase a labor-saving piece of equipment that will last five years assumes the discount rate or the weighted average cost of capital is 10%. Since the labor content is at 12% of $10 million in annual sales, this can be noted as an annual labor cost of $1.2 million (10,000,000 x 0.12). The new piece of equipment is expected to save 20% of labor annually, resulting in a $240,000 reduction in cost each year over the next five years (1,200,000 x 0.20). The cost of the new piece of equipment is $200,000.
In order to determine if the proposal is appropriate and economically viable, the $240,000 savings of labor costs must be discounted to its present ...view middle of the document...

The net present value method of capital budgeting shows that a positive net present value like this one is appropriate and viable for the company. The actual return is greater than the cost of capital.
When it comes to the cost of capital the effects can be significant depending on if it is higher or lower in a long term financial decision. If the cost of capital increases and the present value interest factor for a one-dollar annuity decreases will result in a low net present value. After a while the net present value will eventually become negative. This result would show that the proposal will not generate a return that would cover the company’s cost of capital and should be rejected. If the cost of capital decreases, the same present value interest factor will increase and the results would be a high net present value. This is the opposite effect from the previous scenario. One important tip when it comes to a good proposal in a long-term decision is to be accurate in the estimated cost of capital. This will prevent a good proposal from being rejected and a poor proposal from being accepted.
Capital budgeting techniques are important to assessing which project or investment will create shareholder value. The payback period is an easy technique used to see the amount of time required to recover the initial investment. A lack of consideration for the time value of money makes it more desirable to use alternative techniques. The most common technique for capital budgeting are net present value and internal rate of return, this is due to the methods using the cost of capital as the required rate of return. The importance of these techniques are critical for successfully recommending investment proposals that will eventually lead to the maximum amount of shareholder wealth.

References
University of Phoenix Material. (2016). Capital Budgeting Worksheet. Retrieved from University of Phoenix Material, FIN486 website.

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