A small businessman who runs a successful tool and die shop supplying a nearby f
ID: 2650897 • Letter: A
Question
A small businessman who runs a successful tool and die shop supplying a nearby farm equipment manufacturer, is going to the bank to ask for a loan to expand his plant to install a laser cutting machine. The banker has told him to bring his capital budgeting decision paperwork with him to the bank. The businessman, your friend, asks you for help. What do you advise him to do for capital budgeting analysis? That is, what information will he need to compile and give to you do an analysis. What other paperwork should he be prepared to give the banker, in your opinion?
Explanation / Answer
Answer: 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. We are trying to answer the following question: Will the future benefits of this project be large enough to justify the investment given the risk involved?
It has been said that how we spend our money today determines what our value will be tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values in the future. A very popular approach to looking at present values of projects is discounted cash flows or DCF. However, we will learn that this approach is too narrow for properly evaluating a project. We will include three
stages within Capital Budgeting Analysis:
Decision Analysis for Knowledge Building
Option Pricing to Establish Position
Discounted Cash Flow (DCF) for making the Investment Decision