Академический Документы
Профессиональный Документы
Культура Документы
CJ Manufacturing LLC.
By
Anita Johri
1
Capital Budgeting Project
2
Capital Budgeting Project
Time line:
3
Capital Budgeting Project
Our decision is going to be based by evaluating the two projects based on below
methods.
Payback Period
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback period method is the number of years it takes to recover the initial cost
of the investment. The project that takes the least amount of time is the one we pick.
Formula: The formula to calculate payback period of a project depends on whether the
cash flow per period from the project is even or uneven. In case they are even, the
formula to calculate payback period is:
Payback Period =
Initial Investment
Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for
each period and then use the following formula for payback period:
Payback Period = A +
B
C
4
Capital Budgeting Project
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A.
5
Capital Budgeting Project
Net present value is the present value of net cash inflows generated by a project
including salvage value, if any, less the initial investment on the project. It is one of the
most reliable measures used in capital budgeting because it accounts for time by using
discounted cash inflows.
Before calculating NPV, a target rate of return is set which is used to discount the net
cash inflows from a project. Net cash inflow equals total cash inflow during a period less
the expenses directly incurred on generating the cash inflow.
Calculation Methods and Formulas
The first step involved in the calculation of NPV is the determination of the present value
of net cash inflows from a project or asset. The net cash flows may be even (i.e. equal
cash inflows in different periods) or uneven (i.e. different cash flows in different periods).
When they are even, present value can be easily calculated by using the present value
formula of annuity. However, if they are uneven, we need to calculate the present value
of each individual net cash inflow separately.
In the second step we subtract the initial investment on the project from the total present
value of inflows to arrive at net present value.
Thus we have the following two formulas for the calculation of NPV:
6
Capital Budgeting Project
Decision Rule
Accept the project only if its NPV is positive or zero. Reject the project having negative
NPV. While comparing two or more exclusive projects having positive NPVs, accept the
one with highest NPV.
Based on NPV method we pick the project if NPV > 0 or if NPV = 0. A positive
NPV means the project is expected to add value to the firm and will increase the
wealth of the owners. With two mutually exclusive projects, the project which has
higher NPV is picked.
We use our shadow company YTM, which is 3.8%. We pick project B as the
NPV of project B is higher than project A at 3.8% return.
Based on the NPV profile below we see that at the crossover rate, the NPV for
project A equals Project B. Left to the crossover rate, Project B yields higher NPV
than Project A, so we choose Project B over Project A
7
Capital Budgeting Project
Internal rate of return (IRR) is the discount rate at which the net present value of an
investment becomes zero. In other words, IRR is the discount rate which equates the
present value of the future cash flows of an investment with the initial investment. It is
one of the several measures used for investment appraisal.
Decision Rule
A project should only be accepted if its IRR is NOT less than the target internal rate of
return. When comparing two or more mutually exclusive projects, the project having
highest value of IRR should be accepted.
IRR Calculation
The calculation of IRR is a bit complex than other capital budgeting techniques. We
know that at IRR, Net Present Value (NPV) is zero, thus:
NPV = 0; or
PV of future cash flows Initial Investment = 0; or
8
Capital Budgeting Project
CF1
CF2
CF3
+ ... Initial Investment = 0
1 +
2 +
(1+r)
(1+r)
( 1 + r )3
Where,
r is the internal rate of return;
CF1 is the period one net cash inflow;
CF2 is the period two net cash inflow,
CF3 is the period three net cash inflow, and so on ...
But the problem is, we cannot isolate the variable r (=internal rate of return) on one side
of the above equation. However, there are alternative procedures which can be followed
to find IRR. The simplest of them is described below:
1. Guess the value of r and calculate the NPV of the project at that value.
2. If NPV is close to zero then IRR is equal to r.
3. If NPV is greater than 0 then increase r and jump to step 5.
4. If NPV is smaller than 0 then decrease r and jump to step 5.
5. Recalculate NPV using the new value of r and go back to step 2.
Internal rate of a projects is the expected rate of return on its investment. Its the rate of
return that the firm will earn if it invests in the project and receives the given cash
inflows. In case of mutually exclusive projects we accept the project with highest IRR.
Project A : 12%
Project B: 11%
We will go with Project A based on IRR calculation as it gives higher rate of return.
While NPV and IRR methods are useful methods for determining whether to accept a
project, both have their advantages and disadvantages.
Easy to calculate
Easy to explain
For companies facing liquidity problems, it provides a good ranking of projects
that would return money early.
Disadvantages
9
Capital Budgeting Project
NPV
Advantages:
Disadvantages
Does not give visibility into how long a project will take to generate a positive
NPV
Model assumes that capital is abundant - that is there is no capital
rationing. This is overcome by IRR
IRR:
Advantages:
Disadvantages
10
Capital Budgeting Project
Citations: