Applying Various Capital Budgeting Methodologies (Essay Sample)
5 page paper, APA, Master’s program, Clear concise American grammar
Please use references that have URLs that can be easily verified on the internet
This is a Business Finance SLP.
MOD 3 SLP
Cash Flow Estimation and Capital Budgeting
Applying Various Capital Budgeting Methodologies
The objective of a firm is to maximize shareholder wealth. The Net Present Value (NPV) method is one of the useful methods that help financial managers to maximize shareholders’ wealth.
Suppose the company that you selected for the Module 1 SLP is considering a new project that will have an initial cash outflow of $125,000,000. The project is expected to have the following cash inflows:
Year Cash Flow ($)
If the project’s cost of capital (discount rate) is 12.5%, what is the project’s NPV? Should the project be accepted? Why or why not?
You may use the following steps to calculate NPV:
1. Calculate present value (PV) of cash inflow (CF)
PV of CF = CF1 / (1+r)^1 + CF2 / (1+r)^2 + CF3 / (1+r)^3 + CF4 / (1+r)^4 + CF5 / (1+r)^5 + CF6 / (1+r)^6
Where the CFs are the cash flows and r = the project’s discount rate.
2. Calculate NPV
NPV = Total PV of CF – Initial cash outflow
or -Initial cash outflow + Total PV of CF
r = Discount rate (12.5%)
If you do not know how to use Excel or a financial calculator for these calculations, please use the present value tables. Brealey, R.A., Myers, S.C., & Allen, F. (2005). Principles of corporate finance, 8th Edition. McGraw−Hill. Retrieved June 2014 from http://jcooney(dot)ba(dot)ttu(dot)edu/fin3322/Brealey%20Files/Appendix%20A%20-%20Present%20Value%20Tables.pdf (Please use Table 1)
Also, consider reviewing http://www(dot)tvmcalcs(dot)com for financial calculator tutorials.
Besides NPV, there are other capital budgeting methodologies including the regular payback period, discounted payback period, profitability index (PI), internal rate of return (IRR), and modified internal rate of return (MIRR). These methodologies don’t necessarily give the same accept/reject decisions as NPV.
If the firm has a requirement that projects are paid back within 3 years, would the project be accepted based off the regular payback period? Why or why not? Would the project be accepted based off the discounted payback period? Why or why not?
What is the project’s internal rate of return (IRR)? Based off IRR, should the project be accepted? Why or why not? Recall the project’s cost of capital is 12.5%. What is the project’s modified internal rate of return (MIRR)? Based off MIRR, should the project be accepted? Why or why not?
What are the advantages/disadvantages of NPV, regular payback, discounted payback, PI, IRR, and MIRR? Present these advantages/disadvantages in a table.
SLP Assignment Expectations
You are expected to:
• Describe the purpose of the report and provide a conclusion. An introduction and a conclusion are important because many busy individuals in the business environment may only read the first and the last paragraph. If those paragraphs are not interesting, they never read the body of the paper.
• Answer the SLP Assignment question(s) clearly and provide necessary details.
• Write clearly and correctly—that is, no poor sentence structure, no spelling and grammar mistakes, and no run-on sentences.
• Provide citations to support your argument and references on a separate page. (All the sources that you listed in the references section must be cited in the paper.) Use APA format to provide citations and references.
• Type and double-space the paper.
Whenever appropriate, please use Excel to show supporting computations in an appendix, present financial information in tables, and use the data computed to answer follow-up questions. In finance, in addition to being able to write well, it’s important to present information in a professional manner and to analyze financial information. This is part of the assignment expectations and will be considered for grading purposes.
MOD 3 SLP Applying Various Capital Budgeting Methodologies
The concept of time value of money captures the discounting of future cash flows using a known discount rate. Since the future is uncertain, the time value of money is essential to capital budgeting. The investment appraisal methodologies have different criteria for decision-making, focusing on the conditions to accept or reject projects he Net Present Value (NPV) is favored compared to the other methodologies and to aggregates the discounted cash flows. The paper compares the advantages and drawbacks of various capital budgeting methodologies
Calculation of the NPV
DiscountedYearCash flowPVIFP.V. Cash flows 0125,000,0001-125,000,00012,000,0000.888917778002 3,500,0000.79012,765,350313,500,0000.70239481050489,750,0000.6243560309255115,000,0000.5549638135006120,000,0000.493359196000NPV68,064,625
Regular payback period and discounted payback period
Payback period refers to the time when the initial investment is recovered, and it indicates the riskiness and liquidity of the investment project. Since there are unequal cash flows, the payback period is calculated until the net cash flow is equal to zero. However, the payback period is not used alone. The decision criterion is to accept a project whose payback period is less than the, maximum acceptable payback period (accountingformanagement.org, 2013), and the project needs to achieve the payback soon enough. The regular payback period is 4.14 (4 years and 2 months), meaning that the project would be rejected as it is more than 3 years, which is the management payback period. The discounted payback period is 4.86 (4 years and 10 months) years, and the calculated payback period is more than the cut-off point, and the project is rejected.
YearCash flowPaybackDiscountedDiscounted-125,000,000cash flowspayback12,000,000-123,000,0001777800-123,222,2002 3,500,000-119,500,0002,765,350-120,456,850313,500,000-106,000,0009481050-110,975,800489,750,000-16,250,00056030925-54,944,8755115,000,00098,750,000638135008,868,6256120,000,00059196000
Internal rate of return (IRR) and modified internal rate of return (MIRR)
The IRR highlights whether to continue with an investment project and a higher IRR is preferred as it is associated with more cash flows to investors. When choosing different projects, then the one with the highest IRR is preferred. The project’s IRR is 23.19%, and the decision criterion is to accept a project when the IRR is higher than the cost of capital (minimum required rate of return) and vice versa. Hence the project should be accepted as the IRR (23%) is higher than the cost of capital 12.5%.
The MIRR is similar to the IRR, but the IRR supposes that the cash flows are invested at the IRR (Investopedia, 2015). The MIRR assumes that only the positive cash flows are reinvested at the cost of capital while the initial investment utilize a firm's financing costs (Investopedia, 2015) As such, the MIRR is an improvement of the IRR that reflects the profitability and costs of an investment project (Investopedia, 2015).
MIRR=n â€š (Future value of Positive cash flows, reinvestment rate/ Present value of Initial outlay, finance rate)-1.
Based on the assumption that the finance rate is 12.5%, but there is no known reinvestment rate and using the IRR would give the same MIRR. The MIRR is higher at 20.9% compared to the cost of capital, and the project need to be accepted.
In this case the MIRR= n â€š (PV/outlay)*(1+i)-1
6â€š ($193,064,625/ 125,000,000)*(1.125-1) = 6â€š1.544517*1.125-1=1.07514*1.125-1
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