Capital Budgeting Case Essay

To make the most informed decision the IRRs and payback periods of the projects should be compared in conjunction with the NPVs of the two projects. The NPV analysis of the two projects under consideration indicates that the MMDC Project is the better of the two projects.

Internal Rate of Return is a discount rate in which the net present value of an investment becomes zero. The investment should be accepted if the IRR is not less than the cost of capital. The IRR measures risk, by showing what the discounted rate would have to reach to lose all present value. Futronics Inc. investment would have an IRR of 14.79%. The investment should be accepted since it is greater than the 8% cost of capital. The 14.79% IRR shows the growth expected from the

This essay will discuss the net present value (NPV), payback period (PBP) and internal rate of return (IRR) approaches for a project evaluation. It is often said that NPV is the best approach investment appraisal, which I why I will compare the strengths and weaknesses of NPV as well as the two others to se if the statement is actually true.

The NPV calculation provides a dollar measure of how much a project is expected to add to a firm 's value. Analysts may also want to know what the rate of return on a project is in order to compare it to the cost of capital. This rate is called the internal rate of return, or IRR.

B) What is the project’s net present value (NPV)? Explain the meaning of the NPV.

2. The payback period is the period of time it takes an investment to generate sufficient cash flows to:

A positive NPV indicates that the project earns a return higher than that required to compensate the investor for the risk taken. Therefore, even the most likely scenario should be zero. In a competitive market investors would rush to take advantage of the excess returns. This will result in either an increased initial cost or decreased future cash flows (due to competition), or both. The NPV will as a result be lowered until the project’s return is equal to the required return (NPV = 0).

The NPV profile shows the how sensitive the project’s NPV is to the cost of capital.

The next table shows the present value of each cash flow. Cash flow was multiplied with the PV column. The net present value is $1,078,460 also negative, which results in being higher than the NPV at %10. The weighted cost of capital is %6.

The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to occur entirely at the beginning of the project) by the amount of net cash flow generated by the project per year (which is assumed to be the same in every year). ("Payback Period Formula - AccountingTools,"

Another way to determine if a project is going to add value to the company is by calculating the Internal Rate of Return (IRR) is most easily defined as the return that leads to a project NPV equal to zero. Another way to define the IRR is to consider it as the discount rate that at which the NPV of cash outflows equals the NPV of cash inflows. In other words, it’s the most discounted rate at which a project can possibly break even. In theory, if a project has an IRR greater than the company’s required return rate, then the project will be profitable and the company should proceed with project.

A target payback period will be set by the company and the proposals that recover their initial cost within this time will be acceptable. If a comparison is made between two or more options then the choice will be project with the fastest payback.

The net present value (NPV) is used to evaluate the amount of wealth a certain project is expected to create (Titman, 2011). If the NPV comes out positive the organization should consider moving forward with it; however, if the outcome is negative the project should be rejected. When calculating the NPV the formula that is used is as follows:

Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital investment to break down the profitability of a projected investment or project.

There are three important criticisms of the payback period method. The first is clearly fundamental and relates to the fact that cash flows after the payback period are ignored. So it could be the case that whilst a project produces a large net cash flow (i.e., where cash inflows significantly exceed outflows), they are generated in the later part of the project and may be ignored as this is after the payback period. For example, in the case of project A and B in this question , project B was preferred because of its shorter payback period, but overall project A generates more cash inflows, totaling £2,10,000 as compared to only £2,00,000 in the case of project B. However, project A`s cash inflows were mainly earned in the later years.