The five principles of capital budgeting and their applications

¶ … Capital Budgeting

IMPORTANCE OF PRINCIPLES AS THEY APPLY TO CAPITAL BUDGETING

Capital budgeting is made up of five principles, all of which are instrumental to the entire process of budgeting. The five principles play critical roles, most of which their failure leads to a dangerous process of budgeting. Every relevant cash flow is subject to the incremental cash flows. This principle stands for the changes in the cash flow whenever a project is undertaken. With this principle, it is clear that aspects of the capital budgeting that hail from the cash flow include the externalities and sunk costs. Sunk costs are costs that are hard to be avoided even including the case where the project is undertaken. In contrast, externalities represent the side effects within a project. These side effects have the potential to affect other cash flows within the firm (Laux, 2010).

The principle of incremental cash flows incorporates the sunk costs and the externalities in any capital budgeting process. It is important for any firm to have a focus on the incremental cash flows as this makes the flow of cash geared towards increment and never a drop. Growth is an essential aspect that has to be made possibly relevant at all times. Hence, it is important to consider the need to have a progressive growth, which is based on a managed increment. The other factor in this principle is the need to have side effects manageable. Side effects are influential in that their effects are substantial enough to bring down any progress being made financially and none financially (Baker & English, 2011). When making capital budgets, it is essential to consider the remedy measures that are sort after to control the possible side effects of the entire process of implementation. In the case that the principle of the incremental cash flows is not considered, the capital budgeting or the budget itself is likely to suffer from the vulnerabilities brought about by the side effects together with the sunk costs. Costs are rampant and hence they have to be managed carefully within a good management scale, which is brought about by this principle of capital budgeting.

It is always important to consider cash flows to be based on the opportunity cost. Opportunities are rampant and hence have to be identified and considered consequentially relevant to the firm in the process of making a capital budget. The financing of a project leads to the loss of the cash flow. Such cash flows that will be lost are not limited to the assets accumulated and owned by the firm. They are to be sunk in the case that the project under consideration is undertaken. Opportunities have to be made valid and always ready for takeover in the case that the firm needs a further step towards growth. The cash flow is predicted to be lost in the process of implementing the project at hand. Hence, there is a dire need to have an in-depth consideration of this principle in place (Brigham, & Houston, 2015). In the case that the project managers or those involved fail to consider this principle of capital budget making, the firm or this business is likely to lose its credibility and concern towards what is relevantly the future growth. Opportunities have to be identified and made as solid grounds for developing the future of any business at hand.

The timing of the cash flow is one of the other aspects that have to be considered, as it is often dependent on the time value for the money. Every cash flow that is set to be received currently tends to have an increased worth in the future in the case that it was to be received later. Time is of the essence when making up the consequences of having to deal with cash flow in any firm. Therefore, it is quite instrumental to consider the need of having to dig into the factors of production that are timely and productive in the process and even after the implementation of the project at hand. The worthiness of any production scale is subject to its credibility and time allocation. Therefore, when setting up predicaments for the firm capital budget, it is important to consider what mathematically possible growth in the future is. The cash flow needs to fall within time and has to be set within the required categories as a way of ensuring there is a measurable procedure in its management and growth (Baker & English, 2011).

Cash flows need to be measured based on and on tax. It might not make any sense to measure cash flow before taxes, as this might not represent its present value. The value of the firm is based on the cash flow that is acquired to keep the firm and not the money that is sent to the government in the form of tax. Therefore, it is very important to make sure that everything that is done has been subjected to taxation. Failure to consider this principle is something that is tantamount to failure in balancing the cash flow. Moreover, it is essential to consider the essence of the financial costs that should be reflected in the rates of returns on the project. Some risks are related to the issuance of the rate of returns, risks that are financial in nature (Li, Peng, & Li, 2015).. Every project that is expected to reveal a higher rate of return unlike the cost of the capital has the potential of increasing the value of the firm. Failure to consider this principle makes it hard for the firm to have a weaker balance of the rate of returns.

Part 2

How to calculate annual cash flow

Step one

The cash received by the school from customer invoices is used to determine the total cash received during this year. The school received some of the revenues in $330,000, $330,000, $350,000, $380,000 and $400,000 from the first year to the last year.

Step 2

All the expenses for the different years were added together, right from the first year to the last year. The expenses were as follows:

Year one = $290,000

Year 2 = $303,000

Year 3 = $311,000

Year 4 = $310,000

Year 5 = $320,000

Step 3

The total cash expenses were subtracted from the cash received to determine the cash flow for each year. Cash flows for the first year to the last year were $40,000, $27,000, $39,000, $70,000 and $80,000 respectively.

Step 4:

This cash flow as obtained in the previous step 3 represented the annual cash flows, with a multiplier of a digit.

How to calculate payback period

The payback period was calculated by counting the number of years that the school will take to recover the cash that it invested in the bus project. Initially, the school invested $600,000 in the six busses. The school estimates to have a recovery of the value of the buses within the next five years after which the vehicles will have to be scrapped with no salvage value. Within the five years provided, each year there are revenues of $330,000 $330,000 $350,000 and $380,000 $400,000. The investment took $600,000 to be repaid before the value of the buses run out. Hence the payback period is 2.9 years (1790, 000 divided by 600,000).

Calculate the project\'s Internal Rate of Return (IRR)

IRR stands for the intrinsic rate of return that is wanted out of an investment taking into consideration the amount and time associated with the cash flows. To arrive at this IRR, the net present values were extrapolated as they have been calculated with the use of the random discount rates. Apparently, there was no rate of discount allowable within the school bus business. The discount rates were neglected or given a free pass. The school appears to offer no discounts to the use of the school bus, as it has not been indicated. Moreover, what has been presenting the study is subject to a new entry of the school into this business (Baker & English, 2011).

Risk factors inherent in this capital budgeting analysis

Capital budgeting is one of the tools used in the financial sectors to carry out an evaluation of the value of the long-term project. In the case that managers are trying to differentiate between different investments, a capital budgeting analysis gives the managers a chance to compare the current values of each of the items basing on the projected cash flows together with the available timelines (Li, Peng, & Li, 2015). The rate of return is used to discount every project\'s cash flow. There are risks involved in doing all these activities in the general setting. Some of the risks involved as follows:

Project risk

One of the risks faced comes from the project at hand. The project risks have an approximation that comes from it and helps to bring out the chance that the project is likely to become profitable or fail such profitability as expected mainly because of the errors that arise from the company or the previous evaluation of the project. In the case that a company invests in a project that is out of its expertise, the level of risks increases. Such a move increases the chance that the managers will manage to value the cash flow of the project together with the errors that come up in the process of running the business (Brigham, & Houston, 2015).

In this case, there is a high risk that the school will face in investing in buses, as this is not the exact field that the school has knowledge. Various things have to be done with proper care and attention as everything might just turn out to be a hard task to those involved in carrying out everything within the project. The school has involved in a project that is not firmly within its field of activity. Thus, it is the responsibility of the school to make sure that every involvement has been done with experts and with proper guidance at all times otherwise the risks might go out of hand and hence damage the gains from the project.

Market Risks

The market risks calculate the part of the project and its risk within macroeconomic considerations like the interests\' rates and the inflation rates. This risk happens to increase during the period of a weak economy. In the case that there is a poor economy, the demand for a product decreases hence likely turning the project to become unprofitable. Banks become reluctant to lend during periods of a weak economy, something that leads to the rise of the cost of the capital of any project. Moreover, inflation weakens the long-term real return on nay project. Such factors lead to a rise in the market risk within a project and hence contribute to a higher level of total risks at hand (Laux, 2010).

International risk

In the case that a company a company\'s capital budget project revolves around a different country other than its host, the exposure to the international risk is real. Such risks include the exchange rates together with the political risks that will affect the project. In this case, of a school bus, it is possible that the political nature of the surrounding communities will influence and affect the nature of the project implementation and performance. Unstable political structure negatively affects the project activities. In the case, the exchange rates are not that palatable to the project; it will be forced to incur relative costs together with lower relative gains (Li, Peng, & Li, 2015).

Reference

Baker, H. K. & English, P. (2011). Capital Budgeting Valuation: Financial Analysis for Today\'s Investment Projects. New York: John Wiley & Sons

Brigham, E. F. & Houston, J. F. (2015). Fundamentals of Financial Management. New York: Cengage Learning

Laux, J. (2010). Topics in finance part VI Capital Budgeting. Colorado College Working Paper No. 2011-11

Li, H, Peng, J., & Li, S. (2015). Uncertain Programming Models for Capital Budgeting Subject to Experts\' Estimations. Journal of Intelligent & Fuzzy Systems: Applications in Engineering and Technology. Volume 28 Issue 2: 725-736