Capital budgeting – Island venture In this week’s exercise, an organisation must decide what asset will be most useful, a promenade or a restaurant. Every investment has its cost and by using capital budgeting you will be able to assess which decision will yield the best results. Organisations must consider all of their investment options and the impact that these have on the rest of the company. Opportunity costs are an important part of this and must be considered when decisions are being made. What happens when an organisation decides to purchase one machine over another? What is the opportunity cost of this decision? To prepare for this Exercise: Reflect on how capital budgeting can help an organisation to make long-term investment decisions. What consequences might an organisation face if it does not use capital budgeting? Review the four main methods used to evaluate investment opportunities Think about the disadvantages and advantages of internal rate of return (IRR) and the other three methods, and how these could affect results. Think about the importance of BEP, the margin of safety, and how an organisation’s variable and fixed costs play a role in this. Consider the following scenario: You have just inherited a small island in the Bahamas. The island is near a favourite fishing location, and you are considering two alternative investments. First, you could construct a boat landing that provides grounds for camping. You estimate that the landing will require a £1,000 investment today and that it is expected to generate cash flows of £1,000 per year, forever. Alternatively, you could invest £10,000 today and build a restaurant and ‘beer garden’, which you believe will then generate cash flows of £4,000 per year, forever. You cannot undertake both businesses on the island (they are mutually exclusive), and since both rely on tourists, you believe that the riskiness of each venture is identical (you may assume this to be the case and that the associated required return is 20%). A quick calculation shows that the IRR of the first alternative is 100% and that the IRR of the second alternative is 40%. Hence, according to the IRR criterion, the first option is preferable. In approximately 750 – 1,000 words, address the following: Do you agree with the assessment? Provide alternative capital budgeting evaluations of the two projects and discuss which method is the most reliable. Also discuss what other factors should be taken into consideration. Be sure to articulate the strengths and weaknesses of each technique. Base your answer upon your reading, further research and your own experiences. Please remember to correctly cite all references. Harvard UK referencing must be used.
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