YK Ltd is analyzing its capital expenditure proposals for the purchase of equipment in the coming year. The capital budget is limited to $5,000,000 for the year. Mr Lam, the chief accountant of YK Ltd, is preparing an analysis of the three projects for the senior management. The straight-line method of depreciation is adopted for each project. The residual value of project A is $200,000, whereas the residual value for project B and C is zero. The company expects no liquidity problem in coming years. All revenue and expenses are in cash. YK Ltd require a minimum return on investment of 10%. The initial cost of investment and the projected annual operating income are shown below. Project A Project B Project C $3,200,000 $1,500,000 $4,000,000 Initial investment Projected annual operating income Year 1 Year 2 Year 3 Year 4 Internal rate of return Estimated useful life $250,000 $250,000 $250,000 $250,000 12% 4 years $(100,000) $ 400,000 $ 300,000 17% 3 years $1,000,000 $1,000,000 $ (800,000) $ (900,000) 5% 4 years Required: Evaluate the feasibility of each project by using the Net Present Value, payback period and internal rate of return method. Which project (s) will you select?
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
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