As a manager, you may be responsible for proposing or approving significant, long-term investments by a business. An example of such a long-term investment is a business’ acquisition of manufacturing facilities, machinery and equipment, and working capital needed to launch a new product or to establish productive capacity abroad. Topic 1 described expenditures for plant and equipment as committed fixed costs. Of course, businesses commit financial capital to such investments with the expectation of earning a return on them. The expected return must be sufficiently large to justify undertaking the risks that arise from committing significant amounts of capital to activities whose outcomes (payoffs) are uncertain. In order to determine whether the expected return on investment is adequate, managers apply capital budgeting analysis. Capital budgeting analysis requires managers to determine:
- The business’ required rate of return, referred to as its cost of capital.
- The amount, timing, and risk (uncertainty) of the incremental future cash flows to the business attributable to the proposed investment.
The key feature of capital budgeting is its use of the present value concepts and models you examined in Topic 5. Because the cost of capital of a business and the prospective, future cash flows from a long-term investment are forward-looking estimates, the capital budgeting process is subject to potential judgmental errors or purposeful manipulation. Furthermore, capital investment decisions may be highly sensitive to changes in those estimates. Considering the significant size and long duration of these investments, inappropriate capital investment decisions may have serious financial consequences for a business. Therefore, it is critical that managers install controls over the capital budgeting process.
By completing this assignment, you will learn how to prepare a capital budgeting analysis for a proposed long-term capital investment by a business. As a manager, you may be responsible for proposing or approving significant, long-term investments. Considering the significant size and long duration of these investments, inappropriate capital investment decisions may have serious financial consequences for a business.
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