Overview:
Dalco Construction Inc. is a government-funded company. The major operation it is considering to complete by the 2020 is a major capital investment decision whether to build a bridge or an underground subway train to avoid the heavy traffic congestion. The funding is constraint by $5 Million. Managers of Dalco Inc. have to make a capital budgeting decision to select the best decision making tool to base their selection. For the previous two years Net Present Value (NPV) and Internal Rate of Return (IRR) were the primary decision making tools on which capital budgeting decisions were based upon. The results did not prove to capture the actual results with accuracy and provide support to capital budgeting decisions. The reasons were …show more content…
Precision and technical analysis is required to lead to accuracy of results. An overoptimistic analysis as illustrated in Exhibit 1 by a sensitivity analysis could lead to a rejection.
➢ Incremental cash flow is based on estimates it may create variance from the actual results. Sensitivity analysis in Exhibit 2 illustrates how calculations of NPV are trivial to the analysis if actual cash flows prove to be less than budgeted.
➢ The opportunity cost of capital is not taken into consideration in the discounted cash flow analysis.
➢ Non-financial and qualitative cost and benefits of investing is not taken into consideration in the analysis of budgeted incremental estimated cash flows. The analysis is based purely on financial outcomes of a positive NPV acceptance, no consideration is placed towards analyzing a broader spectrum of whether non financial or qualitative benefits outweigh a negative NPV. Exhibit 3 provides list of factors ignored in the analysis.
➢ Opportunity cost of capital investment is given any consideration in the NPV analysis
➢ Time horizon of the project is an estimate. It is unobservable and unpredictable.
➢ Real option1 values are excluded from the incremental cash flow
Dalco Construction Inc. is a government-funded company. The major operation it is considering to complete by the 2020 is a major capital investment decision whether to build a bridge or an underground subway train to avoid the heavy traffic congestion. The funding is constraint by $5 Million. Managers of Dalco Inc. have to make a capital budgeting decision to select the best decision making tool to base their selection. For the previous two years Net Present Value (NPV) and Internal Rate of Return (IRR) were the primary decision making tools on which capital budgeting decisions were based upon. The results did not prove to capture the actual results with accuracy and provide support to capital budgeting decisions. The reasons were …show more content…
Precision and technical analysis is required to lead to accuracy of results. An overoptimistic analysis as illustrated in Exhibit 1 by a sensitivity analysis could lead to a rejection.
➢ Incremental cash flow is based on estimates it may create variance from the actual results. Sensitivity analysis in Exhibit 2 illustrates how calculations of NPV are trivial to the analysis if actual cash flows prove to be less than budgeted.
➢ The opportunity cost of capital is not taken into consideration in the discounted cash flow analysis.
➢ Non-financial and qualitative cost and benefits of investing is not taken into consideration in the analysis of budgeted incremental estimated cash flows. The analysis is based purely on financial outcomes of a positive NPV acceptance, no consideration is placed towards analyzing a broader spectrum of whether non financial or qualitative benefits outweigh a negative NPV. Exhibit 3 provides list of factors ignored in the analysis.
➢ Opportunity cost of capital investment is given any consideration in the NPV analysis
➢ Time horizon of the project is an estimate. It is unobservable and unpredictable.
➢ Real option1 values are excluded from the incremental cash flow