Applications of Capital Budgeting



Chapter 9 -Net Present Value & Other Investment Criteria

Net Present Value: Problem 8 on page 300

NPV when required return is 11%

Year

Cash flows

Discount

Rate - 11%

Discounted

Cash flow

0

(28,000)

1

(28,000)

1

12,000

0.901

10,811

2

15,000

0.812

12,174

3

11,000

0.731

8,043

NPV

3,028

NPV is capital budgeting technique that is used for profitability purpose. NPV shows present value of future cash flow along with the feasibility of the project. According to the rules of NPV, if NPV of a project is greater than 0 or have positive value, such projects should be accepted since it would add value to the company. If NPV of the project is negative or less than zero, then such projects should be rejected as it would be subtracting value from the firm and would be not profitable in future. It is equal to zero, and then company should be indifferent concerning the investment decision and decision are usually based on other factor and criteria (Ross, Westerfield, Jordan, 2011).

Since NPV of the above project is 3,028 at 11% of discount rate, this project should be accepted since this will increase worth of company.

NPV when required return is 25%

Year

Cash flows

Discount

Rate - 25%

Discounted

Cash flow

0

(28,000)

1

(28,000)

1

12,000

0.800

9,600

2

15,000

0.640

9,600

3

11,000

0.512

5,632

NPV

(3,168)

Now required rate of return has increased to 25% and due to this, NPV of the project is -3,168. As stated above that negative NPV would reduce company's overall worth and it is less than 0, company should not take this project into their consideration and should be rejected (Needles, Powers, Crosson, 2010).

Payback and Discounted Payback: Problems 3 and 4 on pages 299

Problems 3

A

Years

Cash flows

Cumulative Net Cash Inflow

Outlay

($ 60,000)

($ 60,000)

Savings Year 1

$ 23,000

($ 37,000)

Savings Year 2

$ 28,000

($ 9,000)

Savings Year 3

$ 21,000

$ 12,000

Savings Year 4

$ 8,000

$ 20,000

 

 

Payback Period

2 + (|-$9,000| ÷ $21,000)

 

 

2+(9000/21000)

 

 

2+0.4285

 

 

2.4285

Years

 

 

B

Years

Cash flows

Cumulative Net Cash Inflow

Outlay

($ 70,000)

($ 60,000)

Savings Year 1

$ 15,000

($ 45,000)

Savings Year 2

$ 18,000

($ 27,000)

Savings Year 3

$ 26,000

($ 1,000)

Savings Year 4

$ 230,000

$ 229,000

 

 

Payback Period

3 + (|-$1,000| ÷ $230,000)

 

 

3+(1000/230000)

 

 

3+0.004347

 

 

3.004347

Years

Pay Back Period refers to the time needed to recover investment cost. Buy coastal Inc has imposed payback cutoff to three years and Project A payback period is 2.4 years while project B Payback period is 3 years. According to Payback period theories, it is preferable to choose a project that covers investment cost in short duration and considering this; project A is covering their initial investment cost in less than 3 years and it is advisable to go for this project (Peterson & Fabozzi, 2011).

Problems 4

Years

Cash flows

Discount Rate

- 14%

Discounted

Cash flow

Cumulative Discounted Cash Inflow

0

($5,900)

1

($5,900)

($5,900)

1

$3,200

0.8771930

$2,807

($3,093)

2

$4,100

0.7694675

$3,155

$62

3

$5,300

0.6749715

$3,577

$3,639

4

$4,500

0.5920803

$2,664

$6,304

 

 

Payback Period

1 + (|-$3,093| ÷ $3,155)

 

 

 

1+(3093/3155)

 

 

 

1+0.98

 

 

 

 

1.98

Years

Problems 4

Years

Cash flows

Discount Rate

- 14%

Discounted

Cash flow

Cumulative Discounted Cash Inflow

0

($8,000)

1

($8,000)

($8,000)

1

$3,200

0.8771930

$2,807

($5,193)

2

$4,100

0.7694675

$3,155

($2,038)

3

$5,300

0.6749715

$3,577

$1,539

4

$4,500

0.5920803

$2,664

$4,204

 

 

Payback Period

2 + (|-$2,038| ÷ $3,577)

 

 

 

2+(2038/3577)

 

 

 

2+0.569

 

 

 

 

2.569

Years

Problems 4

Years

Cash flows

Discount Rate

- 14%

Discounted

Cash flow

Cumulative Discounted Cash Inflow

0

($11,000)

1

($11,000)

($11,000)

1

$3,200

0.8771930

$2,807

($8,193)

2

$4,100

0.7694675

$3,155

($5,038)

3

$5,300

0.6749715

$3,577

($1,461)

4

$4,500

0.5920803

$2,664

$1,204

 

 

Payback Period

3 + (|-$1,461| ÷ $2,664)

 

 

 

2+(1461/2664)

 

 

 

2+0.548

 

 

 

 

2.548

Years

Summary

Initial Investment

PBP

($5,900)

1.98

($8,000)

2.569

($11,000)

2.548

Average Accounting Return: Problem 6 on page 300

Formula:

ARR: Average Accounting Profit / Average Investment

Net Income 1

$1,854,300

Net Income 2

$1,907,600

Net Income 3

$1,876,000

Net Income 4

$1,329,500

Average Net Income

$1,741,850

Average Investment

$12,000,000

ARR

14.52%

The accounting rate of return for this manufacturing plant is 14.52%.

IRR and MIRR: Problems 7 and 19 on ...