Capital Budgeting Essay

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

  • Type of paper: Thesis/Dissertation Chapter

  • Words: 523

  • Pages: 2

Capital Budgeting

Introduction

The purpose of this paper is to analyze and interpret the answers of the Capital Budgeting Case. I will discuss my recommendation about which Corporation and investor should acquire based on the quantitative reasoning. I also will describe the relationship between the net present value and the internal rate of return for the two corporations that are analyzed.

Capital Budgeting Case

A company is planning in acquiring a new corporation and there are two options with the same cost of $250,000 but both with different 5-year projections of cash flows. The evaluation done to the two corporations (A and B) is based on the Net Present Value (NPV) and the Internal Rate of Return (IRR).

The net present value represents the value the project or investment adds to the investor wealth. The NPV method of capital budgeting suggests that all projects that have positive NPV should be accepted because they would add value to the investment. On the other hand, the internal rate of return is defined as the discount rate that equates the present value of a project’s cash inflows to its outflows. According to the internal rate of return method of capital budgeting, the investment should be accepted if their IRR is greater than the cost of capital.

The results for Corporation “A” shows a NPV of $20,979.20 based on discount rate of 10%. And, we got an IRR of 13.05% which means that is the discount rate that makes the NPV equal or close to $0.00. On the other hand, the Corporation “B” with a discount rate of 11% got a NPV of $40,251.47 and an IRR of 16.94%. A positive NPV is considered a good project, and we want to choose the one with the highest NPV.

Therefore, I would recommend acquiring the Company “B” because it has a higher NPV than the other company. Corporation B will be giving us a current value cash return of $40,251.47 above our 11% required rate of return during the next 5 years. And, if we recalculate the NPV using the IRR of 16.94% it will result on an NPV close to $0.00.

The relationship between NPV and IRR is based on the discount rate used to bring up the cash flows to the present. For the case of Company “B”, with the discount rate of 11%, if we have a NPV of $0.00, our IRR will also be 11%. But, if our NPV is higher than $0.00, our IRR will be also higher than 11%. And, if we have a negative NPV, then our IRR will be less than 11%. In other words, the NPV and the IRR most of the time yield the same result of acceptance or rejection.

Conclusion

In conclusion, the best recommendation is to acquire Company B because it will give us higher current values during the first 5 years and higher returns of the investment.

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Capital Budgeting Essay

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

  • Type of paper: Thesis/Dissertation Chapter

  • Words: 2055

  • Pages: 8

Capital Budgeting

1. Define the term “incremental cash flow”. Since the project will be financed in part by debt, should the cash flow analysis include the interest expense? Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company’s cash flow will increase with the acceptance of the project.

Cash flow analysis should not include the interest expense. We discount project cash flows with a cost of capital that is the rate of return required by all investors. Interest expenses are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.

2. Suppose another juice producer had expressed an interest in leasing the lite orange juice production site for $25,000 a year. If this true, how would this information be incorporated into the analysis? This information would cause a slight change in the decision-making process. More specific, we would not recommend realizing the project if the average net profit per year (including the cost of capital) will be less than or equal to $25,000 which in fact can also be achieved with no risk at all. In order to recommend realizing the project we should either be certain that our profit will be higher than our opportunity cost ($25,000), or have no better alternative to invest the company’s capital.

Of course the above are valid only if there is no cannibalization effect to our sales from the other’s producer’s activities. In the case that we accept the leasing proposal, assume an agreement for 4 years and receive the payment at the end of each period, we have a NPV of $75,933, which is lower than the NPV of our project which is $1,203,759. So, assuming equal life of the projects and no other side-effects, we would prefer to go on with the Lite project and not to lease the production.

The fact that we decide to go on with the Lite project implies that the company will not receive the $25,000 from the leasing. This is an
opportunity cost and it should be charged to the project as A.T. opportunity cost = $Leasing (1 – Tax) = $25,000*(1 – 0.4) = $15,000. Failing to calculate this opportunity cost would cause the new project NPV to be higher than the real one.

Time 0
1st Year
2nd Year
3rd Year
4th Year

25,000
25,000
25,000
25,000
22,322

19,930

17,795

15,887

NPV 75,933

Leasing project NPV calculation

PVIF(12%,1)(25,000) = 22,322
PVIF(12%,2)(25,000) = 19,930
PVIF(12%,3)(25,000) = 17,795
PVIF(12%,4)(25,000) = 15,887

Or

PVIFA(12%,4)(25,000) = 75,933

3. What is the “orange plus” investment outlay on this project? What is the expected non-operating cash flow when the project is terminated at year 4? The net investment outlay consists on the sum of the gross initial outlay, which will represent the depreciation basis, plus the Addition in Net Working Capital. In this project, the gross initial outlay is composed of the following factors: Purchase price of new equipment (Machinery), Transportation cost, Site Preparation cost and Installation cost. The net investment outlay is $918,000.

Year 0
Net Investment Outlay:

Machinery
800,000
Shipping
20,000
Installation
50,000
Plant Preparation cost
25,000
Change in NWC (Inventory)
23,000
Net Investment Outlay
$918,000

Net Terminal Cash Flow corresponds to Salvage value, Tax on salvage value and Recovery on NWC. The expected value is $97,000.

Year 4
Salvage value
110,000
Tax on salvage values
-44,000
Change in WC (Recovery)
31,000
Net terminal CF
97,000

4. Estimating the project’s operating cash inflows. What is the project’s NPV, payback period, IRR and modified IRR.

Year 0
Year 1
Year 2
Year 3
Year 4
Net operating CF

266,880
752,880
774,230
900,411

Decision Measures:

NPV
$1,203,759
Payback period
1.9
IRR
51.2%
MIRR
35.6%

Excel attached with all calculations.

Observations:
Sunk costs such as the spending in R&D, marketing research or last year facilities improvement have been not taken into account because these costs are required to analyze the project and cannot be recovered even if the project is accepted. The opportunity cost of renting the plant is included in the analysis as a after tax cost (cash outflow) because it will not be earned as a result of utilizing the asset for the project. The cannibalization on Classic orange juice is a type of externality that should be included in the analysis as after tax cost (cash outflow) because the new project takes sales away from the existing product. The new project requires an increase in inventories in year 0 and year 3. This will change the net working capital. It will represent an outflow for year 0 and 3, and an inflow when the project terminates because we will recover it.

5. The project is assumed to end in year 4. Do you think that this is realistic? Can you estimate the value of the project’s operating cash flows beyond year 4? State any assumptions you made. This project is reasonable and worth to take it. It will add more value to the company since its NPV is positive and has an attractive IRR and MIRR (higher than WACC). Moreover, the breakeven occurs in year two, in the middle of the project lifecycle, which is a good sign as well.

Calculations to estimate the following years 5 and 6 are done in the excel tab called ‘Estimation Years 5 and 6’. Taking into account that the predicted remaining economic life of the machinery was 4 years, we estimated an extension of two years more for this project, assuming that the machinery salvage value will decrease because of the extra usage and presuming that the other factors will practically remain the same.

The detailed assumptions are:
The project is extended two years more
Growth in sales will be still 20%
Unit price for Lite will continue 2.8$
Unit cost for Lite will be 1.5$
Machinery can be used for 2 years more without incurring any expense Salvage value will drop 80% because machinery has been used for two more years and we assume that its value has decreased Lite will cannibalize Classic following the same behavior (5% decrease in sales) Cost of capital will
remain 10%

Expenses like the insurance will stay the same
The opportunity cost of renting the plant will be identical
We don’t need an increase in our inventory

Given the above assumptions the new measures tell us that, although the salvage value will be reduced, it is worth to increase the life of this project. The NPV is higher because the net cash flows beyond year 4 have increased due to the absence of depreciation cost. Also, IRR and MIRR are superior, 63% and 37% respectively (versus 51% and 36%).

Detailed operating cash flows for the estimated years 5 and 6 are:

Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Net operating CF

266,880
752,880
774,230
900,411
1,061,477
1,285,187

If all the assumptions were real, it would be highly recommended not to terminate this project at year 4 and operate two more years in order to benefit from the positives cash flows of year 5 and 6.

6. Now suppose the project had involved replacement rather expansion of existing facilities. Describe briefly how the analysis would have to be changed to deal with a replacement project. The analysis changes if the new project is a replacement instead of an expansion. We have to consider the incremental revenues (DR), costs (DC) and the relevant depreciation would be the incremental change between the old and the new equipment (DD). For every time, t, CFt = (DRt – DCt- DDt)(1-T) + DDt + Salvage value terms.

The investment cost estimate may have to be adjusted if the project involves replacing one asset with another, presumably newer and more cost efficient. If the old asset is going to be sold, the investment outlay must be reduced by the after-tax proceeds from the sale of the old asset. It will consist of the selling of the old asset (as a positive cash flow) and the taxes on the gain (if the net book value of the old asset is higher than the selling price) or loss on disposal.

7. Does it appear that the project cash flows are real or nominal? Is WACC of the firm real or nominal? Is the current NPV biased, and if so, in what direction? The project cash flows are real because we don’t take into consideration the inflation. However, WACC, in DCF analysis, includes an estimate of inflation. Therefore, the fact that cash flow estimates are not adjusted for inflation (i.e., are in today’s dollars) will bias the NPV downward. Hence, discounting real CF with a higher nominal WACC implies that our NPV estimate is too low. It is important to include inflation when estimating cash flows. Nominal CF should be discounted with nominal WACC, and real CF should be discounted with real WACC. It is more realistic to find the nominal CF (i.e. increase cash flow estimates with inflation) than it is to reduce the nominal WACC to a real WACC.

8. Another project involves the fleet of delivery trucks with an engineering life of 3 years (that is, each truck will be totally worn out after 3 years). However, if the trucks were taken out of service, or ‘abandoned’ prior to the end of 3 years, they would have positive salvage values. Here are the estimated net cash flows for each truck: (Note that the opportunity cost of capital is 10%) Year

Initial investment
And operating cash flow
End-of-year
Abandonment Value
0
-40000
40000
1
16800
24800
2
16000
16000
3
14000
0

a) What would the NPV be if the trucks were operating for full 3 years?

NPV would be negative. The company should not take this project. Time 0
1st Year
2nd Year
3rd Year

16,800
16,000
14,000
15,273

13,223

10,518

NPV3-years -986

PVIF(10%,1)(16,800) = 15,273
PVIF(10%,2)(16,000) = 13,223
PVIF(10%,3)(14,000) = 10,518
CF0 = -40,000
NPV3-years = 15,273 + 13,223 + 10,518 – 40,000 = -986 < 0.

b) What if they were abandoned at the end of year 2? At the end of year1? Abandoned at the end year 2:
Time 0
1st Year
2nd Year
3rd Year

16,800
16,000 + 16,000
0
15,273

26,446

0

NPV2-years 1,719

PVIF(10%,1)(16,800) = 15,273
PVIF(10%,2)(32,000) = 26,446
NPV2-years = 15,273 + 26,446 – 40,000 = 1,719

Abandoned at the end year 1:
Time 0
1st Year
2nd Year
3rd Year

16,800 + 24,800
0
0
37,818

0

0

NPV1-years -2,182

PVIF(10%,1)(41,600) = 37,818
NPV1-years = 37,818 – 40,000 = -2,182 < 0.

c) What is the optimal period for which the company should keep the trucks? Since the only chance to have positive cash flow is to keep the trucks for 2 years, this should be the economic life of this project.

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Capital budgeting Essay

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Capital budgeting Essay
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  • University/College:
    University of Arkansas System

  • Type of paper: Thesis/Dissertation Chapter

  • Words: 1161

  • Pages: 5

Capital budgeting

A – Capital budgeting is an analysis of potential additions to fixed assets, it is part of the long term decisions taken by the top management and involve large expenditures. The capital budgeting is very important to firm’s future. The difference between capital budgeting and individual’s investment decisions are in the estimation of cash flows, risk, and determination of the appropriate discount. B – The difference between interdependent and mutually exclusive projects is that the independent project’s cash flows are not affected by the acceptance of the other, although the mutually exclusive can be adversely impacted by the acceptance of the other. the difference between normal and no normal cash flow stream projects occurs in the signs since for the normal cash flows if the cost ( negative CF) followed by a series of positive cash flows will lead to one change of sign.

On the other hand the non-normal project cash flows have two or more changes of sign C – 1 NPV: is the sum of all cash inflows and outflows of a project C – 2 – The rationale behind the NPV method is that it is equal to PV of inflows minus the cost which is the net gain in wealth. If the projects are mutually exclusive we will choose the project with the highest NPV and here in our case we will choose project S since it has a greater NPV compared to project S (19.98>18.79). If the projects are independent we will choose both. C – 3 The NPV will change if the WACC change; if the WACC increases the NPV will decrease on the other hand if the WACC decreases the NPV will increase. D – 1 Internal rate of return (IRR) is the discount rate that forces PV inflows equal to cost, and the NPV = 0. IRR using excel for project L:

IRR
18.13%

For project S:
IRR
23.6%
D – 2 A project IRR is the same as a bond’s YTM. The YTM on the bond would be the IRR of the “bond” project. D – 3 If IRR > WACC, the project’s return exceeds its costs and there is some return left over to boost stockholders returns. If IRR > WACC, the project is accepted and if IRR < WACC, the project is reject. If projects are independent, we accept both of them, as both IRR > WACC. If projects are mutually exclusive, we accept the one with the highest IRR. D – 4 IRR do not depend on the WACC, so if the WACC changes, the IRR for both projects will remain the same. E – 1

Excel=NPV(rate,CF1:CFn) + CF 0
WACC
NPV L
NPV S
0%
$50.00
$40.00
5%
$33.05
$29.29
10%
$18.78
$19.98
15%
$6.67
$11.83
20%
($3.70)
$4.63

Cross over rate is equal to 8.7%.
CF Differences
0
-60
10
60
IRR = 8.7%

E – 2 For independent projects, both IRR and NPV will lead to the same decision. If projects are mutually exclusive, there is a conflict between the IRR and the NPV. Since we said that NPV is the best method to use in case of conflict, project L will be selected based on this method. F – 1 The slope of the NPV profile depends entirely on the timing of the cash flows; long-term projects have excessive NPV profiles than short-term projects. We conclude that NPV profiles can cross in two situations, first when mutually exclusive projects differ in size: the smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so a high WACC favors small projects, and second when the projects cash flows differ in terms of the timing pattern of their cash flows: the project with faster payback provides more CF in early years for reinvestment. If WACC is high, early CF especially good, NPVs > NPV L (projects studied in class). F – 2

The reinvestment rate assumptions:

-NPV method assumes Cfs are reinvested at the WACC.
-IRR method assumes CFs are reinvested at the IRR.
-Assuming Cfs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. -Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed. F – 3 Some projects will result in different IRR and NPV. The NPV will be selected to decide if the project is going to be accepted or not. We do not use the IRR first because it does not take into account changing discount rates, so it is j not adequate for longer-term projects with discount rates that are will probably vary. Second, the IRR ineffective is a project with a non-normal cash flow streams (mixture of positive and negative cash flows). G – 1 MIRR assumes reinvestment at the opportunity cost =WACC. MIRR also avoids the multiple IRR problem.

G – 2 MIRR does not always lead to the same decision as NPV when mutually exclusive projects are being considered. In particular, small projects often have a higher MIRR, but a lower NPV, than larger projects. Thus, MIRR is not a perfect substitute for NPV, and NPV remains the single best decision rule.

H – 1 Payback period is the number of years required to recover a project’s cost, or “how long does it take to get our money back?”

H – 2 The payback period tells us when the project will break even in a cash flow sense. With a required payback of 2 years, Project S is acceptable, but Project L is not. Whether the two projects are independent or mutually exclusive makes no difference in this case. H – 3 Discounted payback is similar to payback except that discounted rather than raw cash flows are used. H – 4 Discounted payback still fails to consider cash flows after the payback period and it gives us no specific decision rule for acceptance. However, payback is not generally used as the primary decision tool. Rather, it is used as a rough measure of a project’s liquidity and riskiness. I –

1
2
3
CF
-800000
5000000
-5000000

WACC
0,1

To find NPV we used excel:
Excel: =NPV(rate,CF1:CFn)+CFO
NPV
(386 776,86 DT)

Excel: =IRR(CF0:CFn,Rate)
IRR
25%

Excel: =MIRR(CF0:CFN,Rate)
MIRR
5,6%

7

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Capital Budgeting Essay

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Capital Budgeting Essay
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  • University/College:
    University of Chicago

  • Type of paper: Thesis/Dissertation Chapter

  • Words: 805

  • Pages: 3

Capital Budgeting

On this paper the reader will be able to find the rationale in the analysis of a specific capital budgeting case study. Definitions along with explanations related to capital budgeting such as Internal Rate of Return (IRR) and Net Present Value (NPV) will be provided and debriefed. It is extremely relevant to mention that capital budgeting allows the companies to analyze one or more projects to decide eventually which project or piece of equipment would be most profitable or suitable (economically), according to the needs and the capacities the company has.

Before entering into the analysis a little further and into the company chosen let us define what Net Present Value really is. According to Business Dictionary (2011) the definition of NPV is “The difference between the present value of the future cash flows from an investment and the amount of investment. Present value of the expected cash flows is computed by discounting them at the required rate of return.” “NPV is considered as one of the two discounted cash flow techniques, the other one is the Internal Rate of Return”.

There are different types of net present values such as the negative net present value (worse return), the positive present value (better return), and the zero net present value that basically means that the original amount is repaid at the rate established. We mentioned earlier that the other discounted cash flow technique was the IRR, let us define it so we can see the relation. According to www.princeton.edu (2013) “The Internal Rate of Return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments”.

In more specific words it is the effective rate (interest) where the net present value of costs of the investments equals the net present value of the benefits of this investment. Both discounted cash flows techniques are used to make comparisons in flows of income that varies over time. Internal Rates of Return are frequently and commonly used to evaluate the desirability of investments or projects. The main difference between the IRR, and the NPV is that the IRR is a rate that let the companies know the efficiency and quality of the investment made while the NPV solely focuses on the value of that investment. Therefore, we may assume that they are linked but they do not have the same purpose.

After analyzing the projected income of Corporation A and Corporation B it is better to invest in Company B. Income from Operations in Corporation A is greater than Corporation B by $233 at the end of the five-year forecast but still Corporation B generated more revenues. The NPV of Corporation B at the end of the five-year projection is almost twice as the one that the Corporation A ended with. Therefore, in order to invest we may say that Corporation B has more capital to do so. The depreciation expense makes a vast difference at the end of the five-year projection since what Corporation A does not have as revenue in comparison with Corporation B has it in the difference of the depreciation expense which is twice in Corporation B ($10,000).

We may say that Income from Operations, Income Tax, and Net Income is almost the same. There is only a slight difference in the IRR between them of 3.9% that represents a difference at the end of the projection among them of $87.19 but still if it is analyzed thoroughly it is not the same to have an effective IRR of 16.9 out of 40K than from 20K at the end of a five-year projection another reason why the Corporation B was chosen. Furthermore, in a cash flow projection of five years Corporation A has less net cash provided at the end, but we also have to mention that Corporation B had twice as many depreciation expense values (as mentioned earlier) than Corporation A but the cash payment from income taxes in Corporation B was greater. In conclusion if the company relies only on the NPV and the IRR of each corporation to make the proper investment they should choose Corporation B since it provides a better effective rate of return and more capital to invest.

References
Business Dictionary.com. (2013). Retrieved from http://www.businessdictionary.com/definition/net-present-value-NPV.html
www.princeton.edu. (2013). Retrieved from
http://www.princeton.edu/~achaney/tmve/wiki100k/docs/Internal_rate_of_return.html
University of Phoenix Capital Budgeting Case (2013). Retrieved from https://newclassroom3.phoenix.edu/Classroom/#/contextid/OSIRIS:42920011/context/co/view/activityDetails/activity/fbe198e8-2920-493d-bd44-1825fa744ef6/expanded/False/focus-cmt/none

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