Capital Budgeting, Time Value of Money, and Cost-Benefit Analysis

Capita Budgeting, Time Value of Money and Cost-Benefit Analysis

Introduction

Capital Budgeting is a process used to determine whether a project such as investment in a long-term project or building a plant is worth pursuing or not. Sometimes a projects cash flows are analyzed in order to determine whether the returns generated from the project meets the criteria or a target benchmark or not. This is also referred to as Investment Appraisal (Williams, 2008). Ideally speaking, a company should accept and consider all those projects and opportunities which increase the shareholder value. Hence, a financial manager must be capable enough to intelligently decide whether the project is worth pursuing and undertaking or not. In order to do this, the manager should follow a sound process called capital budgeting (Houston, 2009).

The purpose of this report is to analyze a project, named Project A and its revision named as Project B. We did investment appraisal of both the projects in order to identify which project should be accepted and pursued. The three main procedures of capital budgeting utilized in order to analyze the projects are Pay Back period, Internal rate of return and Net Present Value and Payback period is used to determine the number of years required to recover our initial investment or cost of the project. It indicates when our project will reach break even. Net present value is the difference between the initial investment outlay and the present value (PV) of all the Inflows and outflows over the period of the project. Whereas, internal rate of return is a capital budgeting technique used to determine and compare the profitability of the projects or a particular investment (Weston, 1990). It is the rate determined when net present value becomes zero.

Discussion

In this section we have analyzed the two projects namely project A and its revision project B on the basis of, net present value (NPV), payback period and internal rate of return. These techniques will let us determine the profitability of the project based on which the company will make its investment decision.

Project 'A'- Net Present Value

Calculations

The table below shows the net present value calculated for Project A. As per our calculation the net present value for project A is $56, 923. We discounted the net cash flows on the given discount rate which is 12%.

Years

Project A

DF

(Discount Factor)

DCF

(Discounted Cash Flow)

0

($200,000)

1

($200,000)

1

$ 120,000

0.8928571

$107,143

2

$ 90,000

0.7971939

$71,747

3

$ 50,000

0.7117802

$35,589

4

$ ...