CAPITAL BUDGETING: APPLICATIONS OF

INVESTMENT DECISION TECHNIQUES

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CAPITAL BUDGETING: APPLICATIONS OF INVESTMENT DECISION

TECHNIQUES

Making a capital budgeting decision is one of the most important policy decisions that a

firm makes. A firm that does not invest in long$-$term investment projects does not

maximize stakeholder wealth. Capital budgeting decisions determine the future of the

company. An appropriate investment decision can yield spectacular returns. On the other

hand, a misguided and incorrect decision can endanger the very survival of the firm. A

few wrong decisions and the firm may be forced into bankruptcy.

Capital budgeting decisions generally are either replacement decisions or expansion

decisions. Replacement decisions are for purchasing of assets to replace existing assets

that might be worn out, damaged or obsolete. Expansion decisions are made to add

capital projects to the existing assets so as to produce either more of its existing products

or entirely new products. Capital budgeting decisions are deciding which projects a firm

should accept and which it should reject. Various capital budgeting techniques like

payback, discounted payback, net present value $($NPV$),$ internal rate of return $($IRR$)$ and

profitability index may be used to arrive at the most suitable decisions.

Al Mansouri Enterprises is a fast growing firm in Dubai, with the practice of investing

in a few profitable projects each year. For this year the operations manager Mr$.$

Mohamed has identified seven projects listed in Exhibit $1,$ and makes a presentation to

the management committee. Mr$.$ Aly, the CEO of the firm is impressed with the

projects but the finance manager Ms$.$ Hadad raises the concern that the funds available

with the firm for investments are limited to AED $65$ million. Then, the CEO asks the

finance manager to select the best projects from these seven, keeping in mind the

constraints of finance at the firms$$ disposal.

Ms$.$ Hadad, the finance manager of the firm is seeking your help requesting you to

recommend the $$best projects$$ that the firm should accept. To keep it simple, you are

required to consider only the quantitative factors for the selection of the projects. That

is$,$ no other project characteristics are relevant in the selection, except that the

management has determined that projects $4$ and $5$ are mutually exclusive. The firm is

also not interested in going for further borrowing. Refer to your weekly content for

guidance of your analysis.

This case is compiled from published sources, and is intended to be used as a basis for

ta financial assignment rather than to illustrate effective or ineffective handling of

management situation. The firm name, characters, projects and cash flows are

fictional.

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EXHIBIT $1$ Project Free Cash Flows $($UAE Dirhams in thousands$)$

Project number $1234567$

Year

$0(5,000)(10,000)(15,000)(25,000)(25,000)(30,000)(35,000)$

$11,0001,0001,7001,00011,000(3,000)(9,000)$

$21,0002,0001,7001,20010,00010,000(3,000)$

$31,0002,0001,7003,0009,0009,0006,000$

$48003,0001,7004,0008,0006,0006,000$

$58003,0001,7005,0007,0006,0008,000$

$67004,0001,7006,0006,0006,00012,000$

$76004,0001,7007,0005,0004,50012,000$

$86002,0001,7009,0004,0004,50014,000$

$95002,0001,70012,0003,0003,00014,000$

$105002,0001,70020,0005,0003,00014,000$

$1$ GBP $=4\mathrm{.}99$ AED The case has four primary learning objectives:

Explain the mechanisms of capital investment decisions.

Identify the appropriate investment decision techniques suiting the characteristics of the projects.

Apply the capital investment decision techniques on seven projects with different cash outlays.

Demonstrate the ability to evaluate the various capital investment projects and make decisions based on their merits, and availability of funds $($capital rationing$).$

Task

After reviewing the appropriate readings and learning materials, please answer the given questions of the selected case study:

Rank the projects simply by inspecting the cash flows $($you must calculate the sum of cash$-$flow benefits and the excess of cash inflows over cash outflows$).$

Rank the projects using two quantitative methods: NPV and IRR. Assume that all projects are from the same risk class and the appropriate discount rate is $9\%.$ Briefly explain the two methods and specify which quantitative ranking methods are better, and why.

Compare the ranking obtained by the two methods with the ranking obtained by simple inspection of the cash flows. Do they differ? Explain the reasons why they differ or not.

Recommend the $$best projects$$ that the firm should accept when the funds available are limited to AED $65$ million, and Project $4$ and Project $5$ are mutually exclusive.