Financial Analysis - Unit 4

Capital Budgeting

Unit 4 Individual Project - Capital Budgeting

(See excel for calculation)

Project Acceptance

Do you think the project should be accepted? Why?

Investment Technique

NPV

$ 131, 368

PBP

3 years

Based on the above Net present value and payback period, the project of Hot New Café is feasible. According to finance theory, Net Present Value represents Present Value of future cash inflows and cash out flows. The initial investment in this project is $750,000 while after deducting direct and indirect cost, cash flows for five years are constant i.e. $244,500. The formula to calculate Net present value is (Shapiro, 2012):

Net Present Value = (Cash inflows or outflows from investment) - (cash outflows or costs of investment)

[Cash flows/ (1+r) ^n]- Initial Investment

The project acceptance and rejection via Net present value is based on the following rules which are known as Decision Rule.

When Net present value of the project is zero, projects are accepted

When Net present value of Project is positive, projects are accepted

When Net present value of project is negative, projects are rejected

While when there are two projects, project with higher net present value are given more priority than lower NPV (Crundwell, 2012). Since, Net present value of Hot New Café is negative $131,368, it states that this project will add value in the firm and project should be accepted. In short it is favoring project acceptance (Weygandt, Kimmel, Kieso, 2012).

As far as payback period is concern, it is the time duration when initial investment is recovered from yearly cash flows. In order words, it shows how much it is will take to recover the initial investment in the assets. It is express in years. Payback period has been calculated using the following formula (Megginson, Smart, 2012):

Since Payback period of Hot New Café is 3 years, and company has a P/B (payback) policy of not accepting projects with life of over 3 years. Based on this Payback period, project should be accepted since it is recovering the project initially cost rapidly that is 3 year which is within company policy (Dayananda, 2012). This technique is useful since, it offer a clear a picture of initial amount be recovered. But practically, this measure has been given important after Net Present value and according to finance theory, project acceptance should be initially be based on Net present value rather than any other investment technique due to higher drawbacks. Since, Net present Value of this project is positive; it is advisable that project should be taken in to consideration and should be accepted and on the basis of Payback period project is also feasible (Brigham, Houston, 2012).

Overall, NPV and PBP suggests that project should be accepted.

Net Present Value (NPV)

It is rendered as an investment technique that represents present value of future cash flows. In order words, it compares current present value of money to the present value of money in future considering the inflation as well as returns. Net present value of new café is $131,368 and as it is stated before that ...