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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,

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the capital project lasts longer than the payback period, then cash flows the project generates after the initial investment is recovered are not considered at all in the payback period calculation.

• The third, and perhaps most important, flaw is that discounted payback period does

not really give the financial manager or business owner a solid decision criterion upon which to make an investment decision.

• However, payback is not generally used as the primary decision tool. Rather, it is

used as a rough measure of a project's liquidity and riskiness.

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FINANCIAL MANAGEMENT: CAPITAL BUDGETING MINI CASE

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QUESTION D

1. Define the term net present value (NPV). What is each franchise’s NPV? Solution: NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. Below are the calculations on how to calculate the NPV for both franchises:

Franchise L’s NPV is = $18.79 0 | (100.00) 9.09 49.59 60.11 18.79 = NPV L 1 | 10 2 | 60 3 | 80

Franchise S’s NPV is = $19.99 0 | (100.00) 63.64 41.32 15.03 19.99 = NPV S 1 | 70 2 | 50 3 | 20

2. What is the rationale behind the