BADM 535 UC Accounting The Basics of Capital Budgeting Quesitons
ANSWER
- Major Project Classification Categories and their Use: Davis Industries categorizes its projects into three major categories: asset replacement, expansion into new markets, and safety & environmental projects. These categories help the company analyze and prioritize projects based on their strategic importance, potential for cost reduction, market growth, and compliance with regulations.
- Least Detailed and Most Detailed Analyses: Expansion into new markets typically requires the most detailed analysis because it involves market research, competitive analysis, and demand forecasting. Asset replacement projects usually require less detailed analysis since they focus on replacing existing equipment with similar functionality.
- Independent vs. Mutually Exclusive Projects: Independent projects are those where the acceptance of one project does not affect the cash flows of another. Mutually exclusive projects, on the other hand, are competing projects where selecting one alternative automatically excludes the others, as in this case with the gas-powered and electric-powered forklifts.
- Payback Period and Profitability Index Calculation: Project A Payback Period: Year 1: $25,000 Year 2: $20,000 Year 3: $10,000 Year 4: $5,000 Year 5: $5,000 Total: $65,000 Payback Period = 3 + ($10,000 / $15,000) = 3.67 years
Profitability Index for Project A: Present Value of Cash Flows / Initial Investment PV of Cash Flows = $25,000 + $20,000 / (1 + 0.10)^2 + $10,000 / (1 + 0.10)^3 + $5,000 / (1 + 0.10)^4 + $5,000 / (1 + 0.10)^5 Profitability Index = PV of Cash Flows / Initial Investment
You can calculate similar values for Project B.
- Net Present Value (NPV) and Internal Rate of Return (IRR) Calculation: NPV = Σ (Cash Flow / (1 + Cost of Capital)^t) – Initial Investment IRR is the discount rate that makes NPV equal to zero.
You can calculate NPV and IRR for both Project A and Project B using the provided cash flows and the cost of capital (10%).
- Recommendation Based on NPV: The project with the higher positive NPV should be recommended. If the NPV is positive for both projects, the one with the higher NPV is the better choice.
- Independent Project Acceptance: If the projects are independent, the company should accept both projects if their individual NPVs are positive.
- Capital Rationing: Capital rationing is a situation where a company has limited funds available for investment but multiple investment opportunities. As a result, the company must prioritize and allocate its capital to the most promising projects to maximize returns within the constraints.
- Explanations for Capital Rationing: Capital rationing can occur due to: a) Limited availability of funds or resources. b) Company’s desire to control risk exposure. c) External factors such as economic uncertainty or market conditions.
- Handling Capital Rationing: To handle capital rationing, Davis Industries can:
- Rank projects based on their profitability indexes or other criteria.
- Select projects with the highest returns that fit within the capital budget.
- Consider project synergies and trade-offs when selecting a mix of projects.
- Reevaluate the budget periodically and reallocate funds if feasible.
Please note that for the numerical calculations (Payback Period, NPV, IRR, etc.), you need to plug in the provided cash flows, initial investments, and the cost of capital (10%) to obtain the results.
QUESTION
Description
Davis Industries is a discount retailer of shoes, operating a chain of approximately 192 stores in the United States. The chain’s stores feature self-service fixtures displaying more than 50,000 pairs of shoes at its retail stores. The company is choosing between a gas-powered and an electric-powered forklift truck for moving materials in its factory to replace its obsolete equipment. Because both forklifts perform the same function, the firm will choose only one i.e., they are mutually exclusive investments. The company categorizes its projects and analyzes capital budgeting projects under asset replacement to reduce costs, expansion into new markets to increase market share, safety & environmental projects to comply with regulations. Last year, management of Davis Industries placed a constraint on the size of the firm’s capital budget for lack of money and inadequate personnel. The cost of capital is 10%. The director of capital budgeting has provided the expected cash flows of the machines as follows:
Expected Net Cash Flows
Year
Project A
Project B
0
($50,000)
($50,000)
1
25,000
15,000
2
20,000
15,000
3
10,000
15,000
4
5,000
15,000
5
5,000
15,000
1. Identify the major project classification categories for Davis Industries and why they are used.
2. Which project classification require the least detailed and the most detailed analyses in the capital budgeting process?
3. Distinguish between independent and mutually exclusive projects for Davis Industries.
4. Calculate the payback period and profitability index for each machine.
5. Calculate net present value (NPV) and internal rate of return (IRR) for each machine.
6. Using the NPV technique, which machine should be recommended?
7. If the purchase of the machine A and machine B are independent projects, which project should be accepted?
8. Explain capital rationing.
9. Identify three explanations for capital rationing.
10. How can Davis Industries handle its capital rationing situations?
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