Budget in the context of capital budgeting is the plan that describes in detail inflows and outflows of revenue and expenses during the project life. The project life for this case is 10 years. Budget will show the company detail plan of cash inflows and outflows during the 10-year operation period of the aircraft. The two words together – capital budget indicates a list of planned long-term investment outlays for projects. In this case, planned investment is to purchase one of two aircrafts and make additional profits from its operation. Capital budgeting is the method used to determine which among long-term capital investment should be chosen. In this case, we are determining one project – purchase of an aircraft. However, we are using two different aircrafts. For simplicity, two different aircrafts are considered as two separate projects. Capital budgeting process helps strategic planning committee pick up the option, which gives higher rate of return considering time value factor of money. This is why it is important in strategic management. Without capital budgeting strategic management team will enter into a wrong selection. Question 2. Explain why the NPV and IRR capital budgeting tools are superior to the accounting rate of return and simple payback techniques for determining the attractiveness of capital investment opportunities. Answer. ...

This method has two limitations. It does not consider cash inflows for the project beyond payback year, and time value of money. Example: Given below cash flows of two different projects for the same return rate, k = 10 %. Project Investment Cash flow Yr 1 Cash flow Yr 2 A $10,000 $0 $14,500 B $10,000 $ 10,000 $ 2,500 Payback method will select project B, since it pays of in one year. Net present value (NPV) The concept of NPV is included in the following formula, NPV = - Initial Investment + Sum of present value of all cash flows until the end of the project. The basis of this method is in evaluation of time value of future money. NPV measures the additional market value that is created or destroyed as a result of implementation of investment. Example Given below cash flows of two different projects for the same return rate, k = 10 % Project Investment Cash flow Yr 1 Cash flow Yr 2 A $10,000 $0 $14,500 B $10,000 $ 10,000 $ 2,500 NPV A = - 10,000 + 0 + 12,000 / (1+0.1) 2 = - 10,000 + 14,500 / 1.21 = - 10,000 + 11,983 = 1,983 NPV B = - 10,000 + 10,000 / (1+0.1) 1 + 2,500 / (1+0.1) 2 = - 10,000 + 9,090 + 2,066 = 1,156 According to NPV selection method both projects have NPV > 0, but project “A” has higher value. With Payback method project “B” was selected, with NPV method project “A” is selected. Two-year cash flow calculation in NPV method shows that project “A” would maximize the investment. This cannot be said about Payback method. Accounting rate of return This method ignores time value of money.
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