University of Chicago
Type of paper: Thesis/Dissertation Chapter
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.