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Capital Budgeting Project

(Evaluate two mutually exclusive projects)

CJ Manufacturing LLC.

By

Anita Johri

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Capital Budgeting Project

About our company:


CJ Manufacturing LLC., Was formed in year 2000 by Anita Johri and Xianmei Chen.
We are partners with limited liability. We are planning to go public because we wish to
expand our business and raise more capital. We currently manufacture fruit juices. We
are planning to purchase of one of two machines, A or B. They are mutually exclusive
projects, ie we can either go with project A or project B but not both. The machine will
be installed in the manufacturers factory and will produce items for sale. Both machines
take exactly the same input and produce exactly the same final product. The only
difference between the machines is that one is more efficient and therefore has lower
operating costs, resulting in higher net cash flows.

Our Shadow Company:


We assume that the required rate of return is 3.8% (From our shadow company CocaCola).

Capital budget Proposal:

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Capital Budgeting Project

The cash flows of each of the projects are as follows:

Purchase Date 1/1/2014, Sale date 1/1/2023.

Time line:

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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:

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

In the above formula,


A is the last period with a negative cumulative cash flow;

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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.

Using the formula for payback we get the below:


Payback period for Project A is 5.43 yrs. and
Payback period for Project B is 5.57 yrs.
Based on payback period we decide to go with project A as it takes less time to recover
the initial cost of investment, when compared to project B.

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Capital Budgeting Project

Net Present Value Method: (NPV)

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:

When cash inflows are even:


1 (1 + i)-n
NPV = R
Initial Investment
I
In the above formula,
R is the net cash inflow expected to be received each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and
generate cash inflows.
When cash inflows are uneven:
R1
R2
R3
NPV =
+ ... Initial Investment
1 +
2 +
(1 + i)
(1 + i)
(1 + i)3
Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...

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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

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Capital Budgeting Project

Internal Rate of Return (IRR) method:

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

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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.

Advantages and Disadvantages:


Payback Method:
Advantages

Easy to calculate
Easy to explain
For companies facing liquidity problems, it provides a good ranking of projects
that would return money early.

Disadvantages

Does not consider time value of money


It does not take into account, the cash flows that occur after the payback
period.

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Capital Budgeting Project

NPV
Advantages:

It considers time value of money.


NPV measures how much wealth a project creates for the firm and investors.
It is the gold standard for evaluating investment opportunities.

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:

Considers the time value of money.


More intuitive and appealing to business owners to think in terms of rate of
return rather than actual dollar returns.

Disadvantages

Multiple or no Rates of Return - if you're evaluating a project that has more


than one change in sign for the cash flow stream, then the project may have
multiple IRRs or no IRR at all.
Changes in Discount Rates
If IRR > WACC Accept. But if this discount rate changes each year
then it's impossible to make this comparison.
IRRs Do Not Add Up - one of the strengths of the NPV approach is that if
you need to add one project to an existing project you can simply add the
NPVs together to evaluate the entire project. IRRs on the other hand cannot
be added together so projects must be combined or evaluated on an
incremental basis.

Overall, NPV is the best and preferred method.

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Capital Budgeting Project

Citations:

Textbook: Principles of Managerial Finance by Lawrence and Chad


Images: "GoThinkBig.co.uk." 5 Foolproof Questions to Ask in Your Job Interview.
N.p., n.d. Web. 13 Nov. 2013.
"Benefits Realization and Business Cases." : Pros and Cons of NPV, IRR and
Payback Calculations. N.p., n.d. Web. 22 Nov. 2013.
"NPV vs IRR." YouTube. YouTube, 18 Sept. 2013. Web. 22 Nov. 2013.
<https://www.youtube.com/watch?v=6RztxNwerOA>.

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