CAPITAL BUDGETING 5
Capitalbudgeting is a standard process used by organizations during theevaluation and ranking of potential expenditures on investments. Suchventures include rebuilding a plant, buying new equipment, purchaseof delivery vehicles, and construction of additional buildings. Theprocess is important since it enhances the ability of the managers tomake decisions involving significant cash outlays. Moreover, itenables the organization to match its cash outflows and inflows in amanner that add value. Managers can identify projects that suit theavailable capital for investment as well as the desired return on theinvestment (ROI) (Keat et al., 2013, p.477).
Question1,2,3,4,5 and 6
TheIRR of projects A, B, C, D, E and F are 13%, 21%, 21%13%, 24% and 18%respectively. All the projects IRR’s are way above the discountingrate of 8% and consequently, all the projects are acceptable.According to the IRR decision criteria, project E is the mostattractive since it has the highest IRR of 24%. Projects B and C areequally attractive since they have an IRR of 21%. Besides, projects Aand D are equally attractive since they have equal IRR of 13% (Keatet al., 2013, p.477).
Inthe case of the six projects, the net present values for each were asfollows: Project A- 173,119, project B- 136,718, C-36,338 D-38,182,E-99, 024 and F-168, 924. According to the net present values,project A was the most suitable followed by F, then B, E, D, andfinally C. High net present values add more worth to theorganization’s investment. However, there are times the companyfaces a budget constraint (Keat et al., 2013, p.477).
Thelack of sufficient capital renders the company incapable of pursuingall the projects with the highest net present values. Besides, thereare times when projects are mutually exhaustive. In such scenarios,it is difficult for the organization to undertake two or moreprojects concurrently. The group is forced to evaluate whichcombination of projects is suitable based on the costs of capital.Other cases entail the existence of inclusive projects. Such projectsrequire the organization to forfeit other viable opportunities sincethey are crucial to the pursuit of the organization. The current caseentails a situation where the organization has to undertake twoprojects together (Brealey et al., 2011, p.243)
Inthe case of the 450,000-budget constraint, the organization isrequired to undertake the first two dependent projects -B and D.Afterward project C is the next most appropriate project. Theintegral programming in the first instance provides a solution in acase where the company has to undertake project D and B. As indicatedin the report, the original value of the NPV was 235,743. However,the optimum solution for the combination increased the NPV to328,241. The results also indicate that the constraints formaximization were fully satisfied (Brealey et al., 2011, p.243)
In the first criteria, 270,000 of the budget is unutilized. Accordingto the optimal solution, the organization in such a case would bebetter off adopting project C that further leaves 12,000 of theavailable capital unassigned. The amount would provide the highestbenefit if utilized on the projects providing the highest internalrate of return, which is project B (Brealey et al., 2011, p.243)
Inthe following case, the organization is faced with dependencies inproject C and E. The report indicates that there are slacksassociated with the dependencies that result into a misallocation of275,000. The report suggests minimal changes in the original value ofthe objective function as depicted by the initial value of the NPV.Besides, it suggests that the extra-unallocated capital would providemore benefit if utilized in financing project B that further leaves125,000 as unallocated. The residual amount would provide morebenefits if invested in project B since it has the highest IRRamongst the remaining projects A, D and F. However, such a decisionis dependent on whether the projects are divisible since theremaining amount is not sufficient to cover the entire initial costsassociated with project B (Brealey et al., 2011, p.243)
Inthe second scenario, the projects entail a situation with increasedcapital from 450,000 to 550,000. In the case of adopting projects Band D, the initial Net Present value increases from 174,901 to433,792. The two projects related IRR include 21% and 13% for B and Drespectively. The maximum solution contains slacks since 135,203 ofthe available budget remains unused. Once again, if it were possibleto take part of a project, the organization would earn more byventuring into the project with the highest IRR among the remainingprojects that is project C- 21% (Brealey et al., 2011, p.243).
Inthe case of project C and E, the original Net present value increasesfrom 135,363 to 405, 203 as indicated by the answer report. Theadoption of the two projects leaves 375,000 unallocated, and theoptimal solution suggests that project B would be the next mostappropriate project within the same context. However, the adoption ofproject B further leaves an additional 185,000 unallocated. Suchfunds should be invested into the highest IRR project among theavailable projects A, D and F. Consequently, an organization wouldmaximize the returns from the projects by adopting project F since ithas the highest IRR of 18% (Keat et al., 2013, p.477).
Brealey,R. A., Myers, S. C., Allen, F., & Sandri, S. (2011). Capitalbudgeting.Milano: McGraw-Hill Companies
Keat,P.G., Young, P.K.Y. & Erfle, S.E. (2013). Managerialeconomics(7th edition).Upper Saddle River, NJ: Pearson Prentice Hall.