RUNNING HEAD: CAPITAL BUDGETING SCENARIO

Capital Budgeting Scenario Plan B

Kimberly England
FIN 486
Professor Sheila King
August 25, 2014

2 Capital Budgeting

Capital Budgeting
When dealing with investments or long-life projects, companies will use capital
budgeting to determine whether the project will be profitable. Capital budgeting looks at the cost
of the investment and the revenue the investment is expected to bring in over a certain amount of
time. This is essential in the success of a project or investment to be profitable and an asset to the
company. If the estimation proves to provide a negative number, then the project or investment
could and should be scrapped or at least reevaluated.
The present proposal for the company is looking at purchasing new equipment. The
company wants to buy a labor-saving piece of equipment. It is estimated that the labor content is
12% of sales which are $10M each year. The equipment is expected to last 5 years and save 20%
on labor expenses each year. The new equipment will cost $200,000. The weighted cost of
capital is 10%. This paper will use the Net Present Value (NPV), to determine the proposals
effectiveness and whether it is a good decision to purchase the equipment.
Net Present Value
The Net Present Value (NPV) is a reliable decision making method in capital budgeting.
According to Investopedia, NPV is the difference between the present value of cash inflows and
the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability
of an investment or project. It incorporates the discounted cash flow technique to find the worth

of the project in the present and in the future. The NPV formula is

where Ct = net cash inflow during the period, Co= initial investment, r = discount rate, and t =
number of time periods. The present value (PV) of the investment is in important factor when
finding the NPV of a project. The PV comes from the discounting of future amounts to the

3 Capital Budgeting

present. According to Investopedia, net present value is the present value of the cash inflows
minus the present value of the cash outflows. It is a determining factor in finding the NPV of a
project or investment and whether the project or investment should go further. The optimal
concept is to have the NPV greater than zero which means that the company will earn more than
the expected rate of return.
NPV of the Proposal
NPV of using new equipment = Present value of labor cost saved - Cost of new equipment
Present value of labor cost saved = Annual sales*12%*20%*PVAF@10%, 5 years
Present value of labor cost saved = $10,000,000*12%*20%*3.79
Present value of labor cost saved = $909,600
NPV of using new equipment = $909,600 - $200,000
NPV of using new equipment = $709,600
Conclusion
A positive NPV means that the realized return will be greater than the expected return. A
positive NPV means that the returns of the project or proposal are enough to cover the cost and
the financing cost. The higher the expected return, the more chance that the NPV can become
negative; therefore the project or investment may not be a sound investment. As the cost of
capital increases, the NPV decreases. In this proposal, the NPV is well above the PV and should
be purchased.

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References
Investopedia. (2014). Retrieved from http://www.investopedia.com/terms/n/npv.asp