Question

1) Identify the items to be included in the capital budgeting analysis.

2) Ascribe values to the items identified part 1. These values should capture the effects of inflation on the variable cost per unit and the prices of product. Assume that the project will end in five years and the exchange rate is expected to depreciate 3 % each year for the next 3 years, appreciate by 2% in year 4 and 4% in year in year 5.

Answer 1

1.Capital investments are long-term investments in which the assets involved have useful lives of multiple years.  Capital budgeting is a method of estimating the financial viability of a capital investment over the life of the investment.
Unlike some other types of investment analysis, capital budgeting focuses on cash flows rather than profits. Capital budgeting involves identifying the cash in flows and cash out flows rather than accounting revenues and expenses flowing from the investment.

Capital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year. ... You need to go through a three-stage process: Decision Analysis, Option Pricing, and Discounted Cash Flow.

There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment. They include :

a.Payback Period - Payback method is used to know how much time it will take to recover the investment.

b. Discounted Payment Period - This method is the same as the payback period method. The only difference in payback period & discounted payback period is, it considers the discounted cash flow for finding payback period.

c. Net Present Value - NPV is one of the most commonly used methods for investment appraisal techniques. It is the sum of all future discounted cash-flow less initial investment. If the amount is positive then the project should be accepted otherwise it should be rejected.

d.Profitability Index - Profitability index defines how much you will earn.

e. Internal Rate of Return - Internal Rate of Return is the discounting rate used for investment appraisal, which brings the cost of the project & its future cash flow at par with the initial investment.

f. Modified Internal Rate of Return - Accounting rate of return is also known as return on investment or return on capital. It is an accounting technique to measure profit expected from an investment.