VALUING CAPITAL INVESTMENT PROJECTS
Growth Enterprises, Inc
When valuing any project, the free cash flows must be determined in order to be able to successfully implement any method of capital budgeting. Growth Enterprises is currently considering four projects. Each has an equal required initial investment of $10,000,000 which is followed by a set of cash flows different for each project. Depreciation figures for each project were calculated on a straight-line basis. For project A, we used a one year depreciation since we were only given the first year revenue, two years for project B and three years for projects C and D. The required taxes for each project were determining by calculating their EBIT with the given 40% tax rate. For a detailed view of the determination of cash flows please refer to exhibit 1.
The payback period was calculated by determining how long it took each project to recover its initial required investment. The formula we used to determine the payback period looked as follows:
The first project (A) had a payback period of exactly one year since both the FCF and required initial investment were $10,000,000. Project B,’s payback period was 1.33 years, since it recovers part of the investment in the first year and the rest in the following year. Project C recovered its investment after the second year, specifically providing a payback period of 2.1 years. Finally project D’s investment was recovered in the first year given the first year FCF of $10,000,200, making the payback period equal would be in 1 year. (Refer to exhibit 2)
After calculating the FCF for all the projects, we got the IRR’s for each project. We got an IRR of 0% for project A, 32% for project B, 34% for project C, and 43% for project D. Similarly we got the NPV for each project using a WACC of 10% and 35%. Using the 10% WACC we got an NPV of -$1,229,980 for project A, and $3,016,880 for project B, and $5,281,910 for project C, and finally $4,650,990 for project D. Similarly using a 35% WACC, we got an NVP of -$2,592,590 for project A, -$328,960 for project B, and -$229,010 for project C, and finally $821,780.
When it came to ranking each project using the three different capital budgeting criteria, we could see clear a difference in rankings for each of the difference capital budgeting methods. Using the payback period, the best project would be A because it recovers the investment immediately after the first year. Project D had a similar cash flow to project A but D’s first year FCF is $200 higher so we ranked it second; finally 3rd (B) and 4th (C) projects had payback periods of 1.33 and 2.1 years respectively. When it came to IRR, the best project was D, the second was C, the third as B, and finally the worst project was A. Using NPV with a WACC of 10%, the rankings from the best to worst are C, D, B, and A respectively. Using a 35% WACC, the ranking are D, C, B, and A respectively.
We can see that the rankings differ when applying different capital budgeting methods because of the fact that each method is calculated differently and requires different information. The payback period look at the time that it takes for a project to recover its initial cost. It is easy to understand and easy to calculate and is a good tool to use when beginning capital budget analysis. IRR provides the rate of return of a project and takes into consideration all FCF starting from the beginning of a project (t=0). NPV determines the total present value of all project FCFs. It uses weighted average cost of capital as a discount rate to discount the FCFs, and the final number it generates depends strongly on the project’s WACC and FCFs associated with the project.
If we consider the projects to be independent of each other, we can then choose more than one project to fund. If the projects are considered mutually exclusive then we are only able to choose one project. If the projects...