Question

Your firm is contemplating the purchase of a new model commercial airplane which is more fuel efficient that the models your firm is currently flying. On the basis of capital budgeting techniques that we have learned and used, thus far, what are the factors that you will consider in deciding whether or not to purchase and add the newer model planes to your fleet. Explain thoroughly.

Answer 1

Capital budgeting is a process of taking a decision on a proposed project or fixed assets on the quantitative basis, whether to buy or reject it. Here, we used to plan and control our long-term investments.

Factors that must be considered in deciding whether or not to purchase and add the newer model to our fleet are as follows:

1. Fixed Cost: Fixed costs are those cost that can not be avoided and are relevant to be incurred. Such as supervisor's salary. This cost does not depend on the level of activity.
2. Imputed cost: Imputed cost is a cost that is not incurred directly, and is referred to as implicit or opportunity cost. Suppose, company made an investment in the current project, but if the same amount is invested in another project, it could earn 5% from it. Therefore, the foregone investment is an implicit cost.
3. Avoidable cost: We can lower the cost by curbing the activity which is not relevant or by increasing the efficiency.
4.   Incremental Cost: It is a difference in cost when one project is selected over another.
5. Opportunity cost: It is cost foregone by selecting a project over the next best alternative.
6. Sunk cost: sunk cost are the cost that cannot be avoided and are mandatory to be made.
7. Taxes: Taxes are the amount that is required to be paid to the government which is levied on the income of the company and are compulsory to be paid.
8. Weighted Average cost of Capital: It is a weighted average of all the capital investments made in the project that interest on debt, capital gain etc. It represents the required minimum rate of return expected by the shareholders.
9. Deferred cost: These are the cost that can be moved to future with no or little effect on current operations of the company.
10. Common cost: This is a cost that is shared by all the activities of the project and are not allocated to anyone.

Thus, if company is planning to buy a new model plane, it should consider the above factors while applying the budgeting techniques like payback method, discounting method or average accounting method.