When an organization is faced with a decision on whether to invest in a project, capital budgeting and risk assessment are important tools that can help to ensure that an accurate decision is made. Since capital investment in large scale projects can significantly impact the financial performance of an organization, capital budgeting is a process to ensure that the project selection will be beneficial to shareholders and address any risks that the project could run into.
Capital budgeting allows investors to make decisions concerning investments in the long-term assets of an organization. The most important part about capital budgeting is accurately identifying a projectâ€™s risks and the ...view middle of the document...
Net present value is an indicator of how much a project will add value to the company. The internal rate of return is a measure of how efficient the project is to the company. The profitability index considers the ratio between future cash flows and initial investment of the project.
Shareholders in organizations like to invest in projects that are worth more than they cost. Capital project investment decisions are usually made by comparing the economic value of project benefits to economic value of its costs. The difference between the two is called net present value. When calculating the net present value, the project with the positive outcome will be the project that should be pursued. In the simulation, the growth option to enter the wireless communications market yields a higher NPV than expanding Silicon Artâ€™s current digital imaging market.
Silicon Arts faces risks with both capital investment options. In some cases it may be necessary to go beyond the NPV data analysis and use a sensitivity analysis approach to analyze the impact of risk on capital budgets. The use of sensitivity analysis can help to provide further clarity to the capital budgeting process. The sensitivity analysis examines how sensitive a particular NPV calculation is to changes in underlying assumptions (Ross et al, 2005). A downside to a sensitivity analysis is that it treats each variable in isolation. The use of a scenario analysis allows several factors to be considered at the same time (Ross et al, 2005).
The first investment option under consideration is an expansion of their current digital imaging market. One of the upside benefits from this option is that the market share is predicted to grow in year one by 20% if Silicon Arts chooses to pursue this option. The market research report predicts that this project alone will account for 30% of the Companyâ€™s annual revenue during the 5-year period. An additional benefit to this project is the existing good relationship with their equipment vendors and the ability to negotiate the price for their plant and machinery capital expenditures. The best vendor option is to use J&T contractors based upon a higher NPV, IRR, and the ability to phase the payment over a three year period. The land that the facility will be located upon is from a previous transaction a few years back and the $10 million is a sunk cost, or a cost that has been incurred and can not be recovered.
The risks associated with the digital imaging expansion project include sales growth decline in years four and five of the project and continued pricing declines from year two on. Competition is also a larger risk that could impact pricing,...