Memo: Application of Capital Budgeting Techniques (1295 words)

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The conference on evaluating capital projects has been very helpful. You have received a significant amount of information and multiple projects to evaluate to hone your skills. To adequately teach Grammy and the board you will need to answer several questions about the capital-budgeting process. You will do this in a business memo that is no more than four pages long.
Provide an evaluation of two proposed project, both with a 5-year expected lives and identical initial outlays of $110,000. Both of these projects involve additions to a highly successful product line, and as a result, the required rate of return on both projects has been established at 12 percent. The expected free cash flows from each project are as follows:
                               Project A               Project B
Initial outlay          -$110,000             -$110,000
Inflow year 1             20,000                  40,000
Inflow year 2             30,000                  40,000
Inflow year 3             40,000                  40,000
Inflow year 4             50,000                  40,000
Inflow year 5             70,000                  40,000
In evaluating these projects, please respond to the following question:
a. Why is the capital-budgeting process so important?
b. Why is it difficult to find exceptionally profitable projects?
c. What is the payback period on each project? If the organization imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?
d. What are the criticisms of the payback period?
e. Determine the NPV for each of these projects. Should they be accepted?
f. Describe the logic behind the NPV.
g. Determine the PI for each of these projects. Should they be accepted?
h. Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
i. What would happen to the NPV and PI for each project if the required rate of return increased? If the required rate of return decreased?
j. Determine the IRR for each project. Should they be accepted?
k. How does a change in the required rate of return affect the project’s internal rate of return?
l. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?

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Introduction
Every organization is guided by the goal of maximizing the value of the firm so that the returns to the stakeholders are maximized. There are numerous investment opportunities, but the resources available are scarce and it becomes imperative to make the best possible use of resources in an efficient and effective manner. In this report, the principles of capital budgeting have been applied to evaluate two proposals and take a decision.
Importance of capital budgeting process
Capital budgeting process refers to the process of identifying the costs and benefits associated with a project so that informed decisions can be taken. Its importance stems from the fact that it incorporates the strategic and financial aspects of any decision and helps in the creation of accountability and measurability. It provides a systematic, rational and objective manner which can be used by the managers to allocate the scarce resources in the most cost-effective manner.
As there has been an increase in competitiveness across companies, it has become very difficult to find highly profitable projects. If there is an untapped opportunity, all the players would try to tap it and this would reduce its attractiveness. Most of the...
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