Capital Budgeting Case Essay

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Capital Budgeting Case Essay
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  • University/College:
    University of Chicago

  • Type of paper: Thesis/Dissertation Chapter

  • Words: 501

  • Pages: 2

Capital Budgeting Case

With an initial investment of $250,000, we could purchase one of two corporations. By analyzing each corporation we can make an educated decision on which corporation holds the highest return. A five year projected income statement, five year projected cash flow, and the NVP and IRR of both corporations have been created to aid in analysis. After reviewing the information, Corporation A is projected to have a higher return value than Corporation B. Corporation A, would cost us $250,000. In the first year the revenue would be $100,000 and increase 10 % each year. First year expenses would be $20,000; increasing 15 % per year. Depreciation expense each year would be $5,000. The tax rate is 25 % with a discount rate of 10 %. Corporation B, would also cost us $250,000. The revenue in the first year would be $150,000 increasing 8 % each year. Expenses would be $60,000 year one; increasing 10 % each year. The depreciation expense each year would remain at $10,000. The tax rate is 25 % with a discount rate of 11 %. The information from each corporation was applied to create a five year projected income statement.

It would take Corporation B 4 years to produce the net income Corporation A would produce in its first year. Based on the projected income statement alone, Corporation A would give higher return than Corporation B. See attached excel spreadsheet to view the projected income statements for both corporations. A projected cash flow spreadsheet is also attached. The cash flow statements allows us to see how much cash is available one hand. Comparing the cash flow of both corporations help measure the health of cash flow. An important thing to remember is that cash flow does not indicate the overall financial health of the corporations. This does not account for the liabilities and assets, accounts receivable and payable. With this being sad, it is important to look at the numbers on the cash flow spreadsheet. Corporation B has a higher cash flow than Corporation A, but not by a lot. The net present value (NPV) and the internal rate of return (IRR) were both predicted for both corporations. The NPV helps determine the profitability of the investment.

It is done by estimating initial costs, future cash inflows and outflows. NPV is the reflected amount of “wealth” expected to be added as a result of the investment or project. The NPV for Corporation A is $2,520.25 and for Corporation B is $2,532.25. Based on those numbers alone Corporation B adds more profits based on the initial investment. IRR is how to make the NPV = 0. It is typically better to use the NPV to make capital decisions than the IRR. While the some facts favor Corporation B we cannot forget about the projected income statements. The variances between the cash flow and NPV between Corporation A and B are small, yet the difference between the projected net incomes is greater. With all the information collected Corporation A still has the ability to create a higher return.

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Capital Budgeting Case Essay

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Capital Budgeting Case Essay
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  • University/College:
    University of Chicago

  • Type of paper: Thesis/Dissertation Chapter

  • Words: 1091

  • Pages: 4

Capital Budgeting Case

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

Corporation A $20,979.41
Corporation B $40,252.02

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 13.05%

Corporation B 16.94%

Profitability Index, Payback Period and Discount Payback Period The Profitability Index (PI) is just a number and anything 1.0 or higher is confirmation for the project that is being evaluated. The PI is a type of ratio that gives the higher NVP per dollar on an investment. It is better used when you have more than one project comparing. When making decision making measures for the PI methods the best project should be the one that pays off the initial cost outlay.

The PB is the less method used in doing a capital budgeting because it does not consider the time value of the money earned in the project. Looking at Corporation B is shows that it will take 3.31 years to payback the cash inflow to the original cash outflow or the cost of the project. So when making a decision on which corporation to use in PB it is best to take the project that pays off the initial cost outlay in less time. If we look at the PI and PB for Corporation A and Corporation B we will see that Corporation B is much better project than Corporation A. Profitability Index

Payback Period
Corporation A 1.08
Corporation B 1.16
Corporation A 3.64 yrs.
Corporation B 3.31 yrs.

The Discount Payback Period (DPP) does consider the time value of money. It is computed somewhat like the PB method and the only difference is that DPP method uses the discounted cash flow. As we look at the DPP for Corporation A and Corporation B we see that again Corporation B is less time to pay back the cash flow: Corporation A 4.6 yrs.

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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Capital Budgeting Case Essay

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Capital Budgeting Case Essay
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  • University/College:
    University of California

  • Type of paper: Thesis/Dissertation Chapter

  • Words: 432

  • Pages: 2

Capital Budgeting Case

This week, Learning Team C, has completed capital budgeting on Corporation A and Corporation B. We were given $250,000.000 to acquire a corporation. We decided to choose Corporation B. To ensure that our decision was the best, this week, we defined, analyzed, and interpreted the Net Present Value and the Internal Rate of Return for both Corporations. We made the decision based on more financial sense. Below, we have outlined our decision making process.

Defined

What we have done first to help define our Net Present Value and Internal Rate of Return was to project 5 years in advance the income and cashflow would potentially look like. Understanding that Corporation A has a ten percent discount rate each year and Corporation B has an eleven percent discount rate, Learning Team C was able to an income statement and cashflow statement defining the detailed financial statements on how our company would operate the two corporations. The next step in our decision making process would be to analyze what we have detailed.

Analyze generate

To be able to compare the two corporations the team reviewed the projected cash flows for each corporation. What the team learned was that both corporations had a negative Net Present Value, Corporation A NPV is $-966.580.90, whereas B is $-633, 959, 95. Reviewing this report Team C identified that Corporation B began to generate revenue in the coming fourth and fifth years. In addition to the revenue turning over, but so did Corporation B’s Cashflow. Corporation B began to see cashflow by the fourth and fifth year. The team has analyzed, that as the corporation continues to grow due to the Net Present Value. The next step would be to interpret what we just analyzed.

Interpret

How Learning Team C came up in choosing Corporation B was through the Net Present Value. Corporation B will be giving the company, over five years, a current value cash return of approximately $-633, 959, 95 above the eleven percent return. In conclusion, making it the more favorable choice.

Conclusion

This week Learning Team C has defined, analyzed, and interpreted two corporations by completing a capital budgeting exercise. They have agreed that Corporation B would be the company that they would acquire from a business standpoint. Net Present Value was used to help influence and determine this decision.

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Capital Budgeting Case Essay

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Capital Budgeting Case Essay
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  • University/College:
    University of Arkansas System

  • Type of paper: Thesis/Dissertation Chapter

  • Words: 377

  • Pages: 2

Capital Budgeting Case

Your company is thinking about acquiring another corporation. You have two choices—the cost of each choice is $250,000. You cannot spend more than that, so acquiring both corporations is not an option. The following are your critical data:

Corporation A

Revenues = $100,000 in year one, increasing by 10% each year

Expenses = $20,000 in year one, increasing by 15% each year

Depreciation expense = $5,000 each year

Tax rate = 25%

Discount rate = 10%

Corporation B

Revenues = $150,000 in year one, increasing by 8% each year

Expenses = $60,000 in year one, increasing by 10% each year

Depreciation expense = $10,000 each year

Tax rate = 25%

Discount rate = 11%

Compute and analyze items (a) through (d) using a Microsoft® Excel® spreadsheet. Make sure all calculations can be seen in the background of the applicable spreadsheet cells. In other words, leave an audit trail so others can see how you arrived at your calculations and analysis. Items (a) through (d) should be submitted in Microsoft® Excel®; indicate your recommendation (e) in the Microsoft® Excel® spreadsheet; the paper stated in item (f) should be submitted consistent with APA guidelines.

A 5-year projected income statement

A 5-year projected cash flow

Net present value (NPV)

Internal rate of return (IRR)

Based on items (a) through (d), which company would you recommend acquiring?

Write a paper of no more 1,050 words that defines, analyzes, and interprets the answers to items (c) and (d). Present the rationale behind each item and why it supports your decision stated in item (e). Also, attempt to describe the relationship between NPV and IRR. (Hint. The key factor is the discount rate used.) In addition to the paper, a Micosoft® Excel® spreadsheet showing your projections and calculations must be shown and attached.

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