In business decisions concerning capital expenditure appraisal, management should take into account certain variables inherent in the business industry. A typical important principle that comes to mind is the time value of money concept. This encompasses that $1 today is not equivalent than $1 next year. Indeed $1 today is much more valuable. This difference stems from four key factors, which comprise: inflation rate, the risk-free component, general risk premium and property-specific risk premium.
The general increase in prices arising in an economy is a central component of the discount rate. The computation of inflation is normally the result of the Consumer Price Index. Such measurement is quarterly determined by the United States Bureau of Labor Statistics. This encompasses the first constituent of the discount rate as highlighted in the previous paragraph. There are a vast number of methods that can be applied in computing the discount factor. One technique that can be used is the weighted average cost of capital, which is considered in the 9.25% provided in the question at hand.
Other methods can however be adopted such as the capital asset pricing model and the dividend growth model. It is important to note that all the methods outlined comprise
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We have to bear in mind at this stage that inflation is not only important for the time value of money concept. It is also a vital player in the calculation of the cost of capital computed for the capital project. In capital expenditure appraisal management frequently perform the mistake of omitting inflation in the computations named above. Theoretically speaking, the absence of inflation directs the real cash flows to be equal to the actual money changing hands in the project. However, the consideration of inflation leads to a difference between the two variables noted above.
In the aforementioned cases a real discount factor rate is computed, which considers the inflation variable. The formula adopted for such factor is the following: The highly dynamic and fast moving business environment is diminishing the reliability of predictions performed in capital expenditure appraisal. We have to remember that capital projects are normally significant and errors in its evaluation may be vital for the organization. In financial management, a practical method that is usually adopted in order to mitigate such issue is the adoption of sensitivity analysis.
Sensitivity analysis comprises the application of different scenarios in order to determine different values of cash inflows and outflows and thus enhance the financial information for the project at hand. This will thus provide more detailed information in order to aid management in such critical decisions to reach the most optimal decision.
References: Brockington B. R. (1993). Financial Management. Sixth Edition. London: DP Publications. Drury C. (1996). Management and Cost Accounting. Fourth Edition. London: International Thomson Business Press. Lucey T. (2003). Management Accounting. Fifth Edition. London: Continuum.