Capital budgeting involves evaluating investment decisions and requires managers to consider many factors to make a sound decision. These factors include an investment’s net present value (NPV), internal rate of return (IRR), and payback period. In addition, managers must weigh the risk involved in the project when calculating the weighted average cost of capital (WACC). Even with all these analytic tools, evaluating investment alternatives is complex because it relies on projections. Consider the following three scenarios. For each scenario, consider how you would proceed as a manager of this company. Be sure to include the following details to justify your thinking:
- Do you agree with the techniques used in these scenarios? What techniques would you have used, and why?
- Is one analytical tool “better” than another in each scenario? Why or why not?
- What questions would you have concerning the underlying projections in each scenario?
- How would you evaluate the risk inherent in these scenarios? How would this impact the ways in which you evaluate each scenario?
Here are the three scenarios for your consideration:
- You recently started a company that provides pet-sitting services for affluent customers in their homes. Based on customer feedback, you are interested in purchasing equipment that will enable customers to rent equipment to see their pets’ activities from their mobile devices. The net present value (NPV) of this project is positive with an internal return rate of 16.6%, but its payback period is 5.5 years. What do you think is important to consider in evaluating this investment opportunity?
- Your company is considering purchasing a robotic self-driven lawn-mowing machine to maintain its corporate office park grounds. This machine seems costly, but it will pay for itself in 2.5 years by eliminating the salaries of the maintenance employees who currently perform the lawn maintenance. Another manager points out that these employees perform not only lawn maintenance, but also a variety of other upkeep activities. You know the current maintenance staff is well-liked by the employees, who view them as hard workers. How would you frame this investment decision as a manager? What stance would you take?
- Due to recent government regulations, a piece of equipment will cost an estimated $250,000 to dispose of. Management projection from five years ago had figured this piece of equipment would have a $400,000 salvage value. How would knowing this information from the start have impacted your decisions? How does this new information impact the investment’s return?
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