Capital Budgeting Clarification Example

2285 Words Apr 8th, 2015 10 Pages
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Capital Budgeting – Clarification Example

When people hear the term capital budgeting, they usually focus on the budgeting part of the term rather than the capital portion. Actually, capital is the more important aspect because it shows you that you are evaluating a larger expenditure that will be capitalized—in other words, depreciated over time. Remember, a capital expenditure can be many things—a large copying machine, an automated assembly line, a building, or the ultimate in capital budgeting—the acquisition of another entity. What is important about capital budgeting is it allows you to analyze one or more projects so you can intelligently and strategically decide on which project you wish to
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Now, how would you interpret or define your NPV answer? A textbook might define NPV as the present value of future cash returns, discounted at the appropriate interest rate, less the cost of the investment. If you explain it that way to most people, they might give you a blank stare. Yes, you should pick ABC because its NPV is higher than XYZ. However, here is the key interpretation that all will understand—ABC will be giving you, over 5 years, a current value cash return of approximately $472.3K above your 10% required rate of return. In other words, this project will not only meet your 10% required return, but it will give you an additional $472.3K.
The next question is, what total percentage return does the dollar amount represent? This is exactly what IRR tells you. The IRR calculations are as follows:
Internal Rate of Return

ABC
38.58%

XYZ
40.01%
Therefore, your total current valued percentage return on your investment for ABC = 38.58%. IRR is a percentage that will go with NPV most of the time.
NPV told you to choose ABC Company. Your IRR computations are giving you conflicting directions telling you to choose XYZ Company. Consider that IRR can have two problem areas—more than one negative in the cash flow, or if there are large fluctuations in cash flows from year to year. Either of these two problems can result in non-accurate IRR answers. If you noticed, there were some large fluctuations in your cash flow. If you get

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