Capital Budgeting Case
Theresa Cruz, Jesika Watson, Sophina Lane
March 30, 2015
Capital Budgeting Case
Analyzing the Results
In the two capital budgeting cases corporations (A and B) have different revenues values and expenses as well as variable depreciation expenses, tax rates and discount rates. The members of our team had to compute both corporate cases NVP, IRR, PI, Payback Period, DPP, and project a 5-year income statement and cash flow in a Microsoft Excel spreadsheet. The future cash flows of the project and discounts them into present value amounts using a discount rate that represents the project's cost of capital and its risk is what’s needs to forecast the investment. Next, all of the asset's future positive cash flows are reduced into one current value number. Subtracting this number from the original cash expense required for the investment provides the net present value (NPV) of the investment. Using the internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. Relationship between Net Present Value and IRR
Net present value of an investment is equal to the “present value of its annual free cash flow less the investments initial outlay” (Kewon 2013 pg 310). Whenever the NPV is greater or equal to zero we should accept the project, whenever the NPV is negative the project should be rejected. Internal rate of return answers the question of what “rate of return will the project earn” (Kewon 2013 pg 316). IRR is the “discount rate that equates the present value of the project’s free cash flows with the project’s initial cash outlay” (Kewon 2013 pg 316). The discount rate is the rate that is used within capital budgeting that allows for the net present value of cash flow within a project to equal zero. The higher the IRR the more desirable the project is versus the lower the IRR the less desirable the project is. In consequence, the NPV method indirectly assumes that cash flows over the life of the project can be invested at the project’s required rate of return, whereas the use of the IRR method suggests that these cash flows could be invested at the IRR. The better statement is the one made by the NPV that the cash flows can be reinvested at the required rate of return because they can either be returned in the form of dividends to shareholders, who demand the required rate of return on their investments, or invested in a new investment project. (Keown, 2013). The NPV shows that Company B is worth more than Company A. After expenses, taxes and depreciation the company has a value that is better to acquire Corporation B because of a higher IRR of 16.94% and NPV of $40,252.02 than Corporation A whom has an IRR of 13.05% and a NPV of $20,979.41. Net Present Value
However, with the NPV that Corporation B have it will be give the corporation, over 5 years, a current value cash return of about $40K above the 11% required rate of return. In other words, this plan will not only meet the 11% required rate, but it will give the company an additional $40. Internal Rate of Return
When a project is reviewed with the hurdle rate in viewpoint, then the greater the IRR is above the hurdle rate, the greater the NVP, and on the contrary, the more the IRR is below the hurdle rate , the lower the NVP. When using the IRR, the decision rules are as follows: If IRR > hurdle rate, accept the project
If IRR< hurdle rate, reject the project.
In order for a project to be accepted, the IRR must be greater than or equal to the hurdle rate. If the company is deciding between projects, then the project with the highest IRR is the project to be accepted. As we look at the IRR for both corporations we see that Corporation B is higher than Corporation A and this is why we as a team choose Corporation B. Corporation A
References: Keown, A. J., Martin, J. D., & Petty, J. W. (2013). Foundations of Finance, 8th Edition. [VitalSource Bookshelf version].
Retrieved from http://online.vitalsource.com/books/9781269882194/id/ch10lev2sec2
Keown, A. J., Martin, J. D., & Petty, J. W. (2013). Foundations of Finance, 8th Edition. [VitalSource Bookshelf version].
Retrieved from http://online.vitalsource.com/books/9781269882194/id/ch10lev2sec5
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