(a) Why is the capital budgeting decision crucial and important for a firm? Stat

Question

(a) Why is the capital budgeting decision crucial and important for a firm? State why the capital budgeting errors are so costly?     (5 marks)

(b) Suntex Berhad is considering a major expansion of its production line and has estimated the following free cash flows associated with such an expansion. The initial outlay associated with the expansion would be $ 1,950,000 and the project would generate free cash flow of $ 450,000 per year for six years. The appropriate required rate of return is 9%. Answer the followings:

i) Calculate the net present value             (6 marks)

ii) Calculate the profitability index              (3 marks)

iii) Calculate the internal rate of return       (3 marks)

iv) Should this project be accepted?           (3 marks)

Explanation / Answer

Both financial and investment decision are pillars in making successful capital investment decision.

FCF is calculated as:EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure

a.The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project. Importance:- Important decisions like mergers and acqusitions involving billion of stakes. Develop and formulate long-term strategic goals Seek out new investment projects Estimate and forecast future cash flows Monitoring and Control of Expenditures The capital budgeting decisions are taken with a view of certain predictions in the future,the functioning and existance of the company will be threthened if the budgeting decision goes wrong(budgeting errors) as it involves very huge stakes of the company and the company may loose huge amount if it goes wrong

Both financial and investment decision are pillars in making successful capital investment decision.

b. Initial outlay 1950000 1 2 3 4 5 6 Rate of return 9% Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Cash flow -1950000 450000 450000 450000 450000 450000 450000 Discounted cashflow -1950000 412844 378756 347482.6 318791.3 292469.1 268320.3 Net cash inflow 2018663 Net cash outflow -1950000 NPV 68663.37 Profitability index 1.035212 Net cash inflow/initial investment IRR 1.08% Yes the project can be accepted asitvgives positive returns Free cash flow is calculated as operating cash flow minus capital expenditures.

FCF is calculated as:EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure

It can also be calculated by taking operating cash flow and subtracting capital expenditures.

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