University Finance: Evaluating a Capital Budgeting Case Study Report

This report provides an in-depth evaluation of a capital budgeting case study. It begins by outlining key principles such as focusing on cash flows, incremental cash flows, accounting for time, and accounting for risk. The report then delves into the specifics of the case study, including the estimated net cash flows, payback period, internal rate of return (IRR), and net present value (NPV) of the project. The analysis includes a comparison of the capital budgeting techniques, highlighting the superiority of the net present value method. Finally, the report identifies and discusses various risk factors inherent in capital budgeting analysis, such as theft, decline in demand, and rise in costs, providing a comprehensive overview of the financial considerations and potential challenges associated with the project.

Running head: EVALUATE A CAPITAL BUDGETING CASE STUDY
Evaluate a Capital Budgeting Case Study
Name of the Student:
Name of the University:
Author’s Note:
Course ID:

1EVALUATE A CAPITAL BUDGETING CASE STUDY
Table of Contents
Part I:..........................................................................................................................................2
1. Focus on cash flows, not profits:........................................................................................2
2. Focus on incremental cash flows:......................................................................................2
3. Account for time:...............................................................................................................3
4. Account for risk:................................................................................................................3
Part II:.........................................................................................................................................4
1. Estimated net cash flows of the project:............................................................................4
2. Payback period of the project:............................................................................................4
3. Internal rate of return of the project:..................................................................................5
4. Net present value of the project:........................................................................................5
5. Evaluation of the capital budgeting techniques:................................................................6
6. Risk factors inherent in capital budgeting analysis:...........................................................6
References:.................................................................................................................................7

2EVALUATE A CAPITAL BUDGETING CASE STUDY
Part I:
All general managers have to encounter capital budgeting decisions in their career
courses. In capital budgeting, the financial managers use few principles, which are taken into
consideration irrespective of the project type. Some of the highly significant principles are
elaborated in this essay. These principles are enumerated briefly as follows:
1. Focus on cash flows, not profits:
As pointed out by Almazan, Chen & Titman (2017), cash flows are described as the
net amount of cash and cash equivalents, which move in and out of a business organisation.
In case of capital budgeting, cash flows are deemed to be more important, instead of business
profits, as per the perceptions of the business managers. The main reason behind the
concentration on cash flows, instead of accounting profits, is that the organisation receives
these flows, which could be used for reinvestment in future. Thus, critical investigation of
cash flows would help the managers in examining the timing related to cost or benefit. Along
with this, the main reason behind such managerial interest is that cash flows are considered
after tax, since such flows are available only to the organisation. Furthermore, this could be
adjudged as the sole incremental cash flows having managerial interest, as by viewing the
project from the perspective of the organisation, the incremental cash flows are marginal
project benefits. Therefore, they provide increased value to the organisation from project
acceptance.
2. Focus on incremental cash flows:
When an investment is made in a project, it should have the capability of generating
adequate cash flows for the organisation. Incremental cash inflows imply the additional cash
flows that the organisation generates by making investment in a new project over another

3EVALUATE A CAPITAL BUDGETING CASE STUDY
project. These cash flows need to be adequate for covering the additional costs needed to be
incurred by the organisation due to the project selection (Andor, Mohanty & Toth, 2015).
3. Account for time:
The cash flows, which are generated during the economic life of a project, need to be
ascertained depending on the time value of money. The reason is that at the time of
undertaking decisions at the current date, the cash flows are valued at the current date as well
for avoiding inflation. In case; the cash flows are inflated, they would result in investment in
an inaccurate project, which might not fetch the desired amount needed by the organisation
(Chittenden & Derregia, 2015).
4. Account for risk:
One of the significant risks inherent in the process of capital budgeting is the risk of
failure associated with a project or it might not lead to the projected profits. Therefore, it is
necessary to take into consideration all the risks at the time of undertaking capital budgeting
decisions. Each risk is involved in addressing areas where some sort of volatility could
compel the managers of an organisation to alter the plan. Various techniques are available for
gauging, preparing to face and plan for such risks. Some of these techniques constitute of
scenario analysis, sensitivity analysis, break-even analysis and others (De Andrés, De Fuente
& San Martín, 2015). In case; these risks are not dealt with properly, they might result in
series of losses after the projects are undertaken.
For ascertaining the feasibility of a project, the managers need to take into account
these capital budgeting principles. However, they do not ensure the entire project success,
since future uncertainty controls the other factors.

4EVALUATE A CAPITAL BUDGETING CASE STUDY
Part II:
1. Estimated net cash flows of the project:
For arriving at the net cash flows, all the expense items including driver costs, repairs
and maintenance and other costs after which they are deducted from sales revenue or cash
inflows.
2. Payback period of the project:
By using the initial investment of $600,000 of the project, the cash inflows are
summed until the recovery period. This period is considered as the payback period (Johnson
& Pfeiffer, 2016).
As the cumulative cash flows have been positive in the fourth year, this implies that
the school would be able to recover the initial outlay within three years and few months. For
knowing about the exact time in the fourth year where the initial investment would be

5EVALUATE A CAPITAL BUDGETING CASE STUDY
recovered, the balance after third year is divided by the fourth year’s cash inflows and the
figure obtained is added with 3.
3. Internal rate of return of the project:
At first, the present value of cash inflows is calculated by using the weighted average
cost of capital of 10.5%. After that, NPV is calculated by deducting the initial investment
from the present value of cash inflows (Rossi, 2014). As the NPV is found to be positive, trial
and error method is used for obtaining a rate of return that would provide $0. For this case,
IRR is computed by using the Excel function.
4. Net present value of the project:
Firstly, the total present value of cash inflows by multiplying the cash inflows with
the discounting factor value. After this, the initial investment of $600,000 is subtracted from
the total present value of cash flows to arrive at the net present value of $30,966.

6EVALUATE A CAPITAL BUDGETING CASE STUDY
5. Evaluation of the capital budgeting techniques:
The school needs to use net present value method for undertaking the project selection
decision. This is because this method provides an overview of the rise in owners’ wealth
arising from project acceptance at the existing cost of capital. Net present value is superior to
payback period, as it considers time value of money. Moreover, it is superior to internal rate
of return as well, since the latter only provides an overview of the increase in cost of capital
before the acceptance of the project (Rossi, 2015).
6. Risk factors inherent in capital budgeting analysis:
Certain risk factors are identified in this capital budgeting analysis and they are stated
briefly as follows:
Theft:
If one or more buses are stolen, revenues would be lowered and the management does
not capture this possibility while undertaking the investment decision. If theft takes place, the
school would incur significant loss.
Decline in school bus demand:
If it is assumed that numerous schools enter the business or they purchase their own
buses for the transportation of students to attend events, the demand for school buses would
fall resulting in revenue minimisation. The capital budgeting techniques fail to address this
risk (Schönbohm & Zahn, 2016).
Rise in costs:
If there is rise in costs in future, there would be definite fall in net cash flows. For
instance, with the increase in fuel cost, the net income expected from the project would be
minimised. Hence, capital budgeting decision does not cover this risk.

7EVALUATE A CAPITAL BUDGETING CASE STUDY
References:
Almazan, A., Chen, Z., & Titman, S. (2017). Firm Investment and Stakeholder Choices: A
Top‐Down Theory of Capital Budgeting. The Journal of Finance, 72(5), 2179-2228.
Andor, G., Mohanty, S. K., & Toth, T. (2015). Capital budgeting practices: A survey of
Central and Eastern European firms. Emerging Markets Review, 23, 148-172.
Chittenden, F., & Derregia, M. (2015). Uncertainty, irreversibility and the use of ‘rules of
thumb’in capital budgeting. The British Accounting Review, 47(3), 225-236.
De Andrés, P., De Fuente, G., & San Martín, P. (2015). Capital budgeting practices in
Spain. BRQ Business Research Quarterly, 18(1), 37-56.
Johnson, N. B., & Pfeiffer, T. (2016). Capital budgeting and divisional performance
measurement. Foundations and Trends® in Accounting, 10(1), 1-100.
Rossi, M. (2014). Capital budgeting in Europe: confronting theory with
practice. International Journal of managerial and financial accounting, 6(4), 341-
356.
Rossi, M. (2015). The use of capital budgeting techniques: an outlook from
Italy. International Journal of Management Practice, 8(1), 43-56.
Schönbohm, A., & Zahn, A. (2016). Reflective and cognitive perspectives on international
capital budgeting. critical perspectives on international business, 12(2), 167-188.