Part I:
Virtually all general managers face capital-budgeting decisions in the course of their careers. The most
common of these is the simple yes versus no choice about a capital investment. Regardless of the type of
project, however, certain principles of capital budgeting should always be considered. The most important of
these principles are:
-Focus on cash flows, not profits.
-Focus on incremental cash flows.
-Account for time.
-Account for risk.
Now, write an essay discussing the meaning and importance of each of these principles as they apply to capital
budgeting. Evaluate the importance of each principle and discuss the consequences of ignoring any of these principles.
You must use a minimum of three scholarly sources to support your discussion.
Part II:
A private school is considering the purchase of six school buses to transport students to and from school
events. The initial cost of the buses is $600,000. The life of each bus is estimated to be 5 years, after which
time the vehicles would have to be scrapped with no salvage value. The school’s management team has
derived the following estimates for annual revenues and cost for the next 5 years.
The buses would be purchased at the beginning of the project (i.e., in Year 0) and all revenues and
expenditures shown in the table above would be incurred at the end of each relevant year.
Because schools are exempt from taxes, the school’s corporate tax rate is 0 percent. A business consultant
has advised management that they should use a weighted average cost of capital (WACC) of 10.5% to
evaluate this project.
-Prepare a table showing the estimated net cash flows for each year of the project. Explain all steps involved in
your calculation of the Year 1 estimated net cash flow.
-Calculate the project’s Payback Period. Explain in your own words, all steps involved in the calculation
process.
-Calculate the project’s Internal Rate of Return (IRR). Explain in your own words, all steps involved in the
calculation process.
-Calculate the project’s Net Present Value (NPV). Explain in your own words, all steps involved in the
calculation process.
Which of the three evaluation techniques that you computed (i.e., payback period, IRR and NPV), should the
firm use to make its decision of whether or not to accept this project? Why did you choose this technique? Is
one of these techniques better than the others and if so, why?
Finally, what are some risk factors inherent in this capital budgeting analysis? Make a list of at least three items
that could cause the outcome of this project to be substantially worse than management currently expects (as
reflected in their revenue and cost estimates, WACC estimate, etc.). Fully explain each of the risk factors you
identify
Sample Solution