Identify four reasons that capital budgeting decisions by managers are risky

  1. Identify four reasons that capital budgeting decisions by managers are risky.
  2. Why is an investment more attractive to management if it has a shorter payback period?
  3. Why should managers set the required rate of return higher than the rate at which money can be borrowed when making a typical capital budgeting decision?
  4. Why does the use of the accelerated depreciation method (instead of straight line) for income tax reporting increase an investment’s value?

 

After you’ve completed the questions above, please provide a brief explanation of how this information is important in managerial decision making.

 

 

When manager does capital budgeting, the manager wants to know few factors – how much the investment would cost, cash flow due to the investment, interest rate to calculate the future value of the cash flow , inflation that impacts the future cash flow but there are other factors often imposes risk on budget allocation process, for example managers often decided based on ethical reasons, being short term focused and ignoring the long term goals etc.

Inflation and tax adjusted future cash flow – is important and a manager can ignore tax or future inflation (which might change anyway without anyone having any control over it) to get a proposal approved.

It is important to remember that income tax has to be paid per the law in the country and the inflation can increase too, and both can impact future cash flow inversely. If tax or inflation goes up the future cash flow will come down. The NPV or IRR should factor in future inflation in cash flows.

Qualitative factor – Sometimes NPV and IRR can show an investment might not bring in positive cash flow, yet manager can go ahead with the decision of capital budgeting.

And this capital allocation might be important because it might be to comply with some regulations, or use the best technology available and stay ahead of the competition. These are few reasons which will not impact future cash flow positively yet these reasons are important to do well in business.

Ethical Issues – A manager may or may not allocate budget based on the fact how that will impact him personally. Consider a manager gets bonus from profit the company makes, and making any investment would take a part away from the profit, and in that case just because the manager would get a reduced bonus amount, could take a decision not to make the investment. An ethical issue can be just the opposite too, a manager can simply inflate the future cash flow to get an investment proposal approved.

A company should not be just reward managers for meeting goals, or the reward should come in from on equity, so the manager actually sees a benefit in company’s long term growth prospect.

Ignoring long term goals – is similar to the ethical issue in few aspects. Manager might postpone investment decision to meet immediate goals or current goals just to make sure his performance is good per the benchmark. And in this process the company might miss out on an investment window that could have yielded better results in long run. And like I mentioned in the previous section, a manager can inflate numbers to get an investment proposal passed to which might yield negative result for the company in long run. These are all risks when managers do capital budgeting in any company.

 

 

Why is an investment more attractive to management if it has a shorter payback period?

According to Investopedia, Payback period is the time take for a company to regain the original investment amount and when the net cash flow equal to zero. The simple reason is the present value of future cash is worth less. The faster the manager can recoup the investment, the sooner he / she can put that money to work in another investment.

Present value of future cash is always worth less to the manager based on the interest rate and time.

For example, Say in one investment would yield $1000 in 1 year, and annual interest rate is 5%

Present value of that $1000 is = 1000/(1 +.05) = $952.38

If the 2nd year cash flow projection is $1000 too, then the present value of that amount would be  1000/(1+.05)^2 = $907.02

As you can see in this example, the present value of same $1000 in future is going down based on the rate of interest and time. So managers prefer a shorter payback period so that they can put the money back to work in another investment. According to Investopedia, managers should always go for the shorter payback period projects.

 

 

  Why does the use of the accelerated depreciation method (instead of straight line) for income tax reporting increase an investment’s value?

Let us take an example, say one company makes an investment worth $1000 and it will last 5 years. The tax rate is 25% and we will keep the future cash flow fixed that is $5000 for next 5 years. There is no salvage value on the investment.

Let us find out what if the company decides to use accelerated depreciation method and claims depreciation value in 2 years instead of 5 years.

So total present value of the cash flow would be

  year 1 year 2 year 3 year 4 year 5
Post Tax cash flow 3750 3750 3750 3750 3750
Depreciation 1250 1250      
Present value 4545.5 4132 2817.38 2561.25 2328.38 16384.5

 

But if the company decides to go in linear so $1000 over 5 years and depreciation expense is $2000 each year , let us check the present value of the cash flow with that, keeping other data points constant

  year 1 year 2 year 3 year 4 year 5
Post Tax cash flow 3750 3750 3750 3750 3750
Depreciation 500 500 500 500 500
Present value 3863.68 3512.2 3193.03 2902.75 2638.83 16110.48

 

 

We can see in 2nd case the total present value of cash flow is actually lower than when manager uses accelerated depreciation. The reason behind this is, when accelerated depreciation is used, company saves more money, and new cash flow increases, and the future cash is less than the present cash, so having more cash flow in initial helps achieve a better cash flow in present value terms.

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