Finance - Capital Budgeting - Other complex issues

Question 1

Explain what asset-based replacement is used for in capital budgeting

Answer 1

For asset replacement - figuring out the replacement cost of the old asset using NPV new asset may be more efficient
- Only incremental cash flow is relevant. Cash flow change when using new machine vs old machine
- Remember the comparison of all the cash flows between continuing to use the old and buying a new machine

Question 2

What are some risk categories to be assigned

Answer 2

Advantages - if firms are more likely that various divisions or operating units will be homogeneous
By risk classes
By investment categories
By operating division

-Using the average rate led to economic distortion and resulted in low-risk projects being penalized because they are subjected to high a discount rate

Systematic risk - using CAPM measured by to project discount rate = Rf + B(Rmp)

Question 3

Explain what is capital rationing and when is it used for capital budget

Answer 3

Rationing is based on internal constraints/limits on several new investments that may be undertaken and therefore the company has to select
- Management may limit the number of projects due to the capacity limitation of the organization to pursue multiple projects simultaneously to reduce risk

Question 4

What is the profitability index and NPV

Answer 4

Profitability index (PI) - NPV of after-tax net future cash inflow

Question 5

What is the difference between Independent project, mutually exclusive and interdependent

Answer 5

1. Independent project - accepting one project doesn’t influence the decision to accept or reject any other project. Assuming the firm does not face financing constraint
2. Mutually exclusive - accepting one project means that the other project is automatically rejected.
3. Interdependent - cash flow is related and the viability of one project of conditional on accepting another project

Question 6

Provide some qualitative consideration that are to be determine for capital budgeting

Answer 6

Qualitative information assesses for factors that cannot be measured financially. Qualitative factors include:
1. Is the investment consistent with corporate strategy, policies, and objective
2. Are there any social, political, or technological impacts for the investment
3. Are there any environmental considerations associated with the investment
4. Are the suppliers or other resources available, in the way of skilled management and labor
5. will the project negatively impact the company’s reputation

Question 7

What are some reasons for capital budgeting using an information technology project

Answer 7

• IT investment has unique characteristics in forecasting incremental cash flow and capital budgeting analysis challenging
  Reasons for investment
  1. Keep the existing system operational for day-to-day processing
  2. Improve or expand existing system
  3. To make fundamental changes

Question 8

Provide some development and implementation stages that are used and the types of cost incurred

Answer 8

Many stages of development and implementation stages
1. Planning, need assessment and development
2. Cost-benefit analysis
3. Testing - Does not implement, includes selecting a test site or test data, ensuring that testing is done at normal, expected loads, ensure integrity and data
4. Implementation and data conversion - Delivery of the final product, the new system is implemented and customized where required. Technical manuals, user manual, an training manual
5. Ongoing maintenance of the system

Types of cost - The more complex the improvement is, the longer and costlier each stage will be.
Forecasting cost, important to include
1. Hardware 2. Software 3. Subscriptions, 4.services 5. Internal resource