Various techniques of capital budgeting

3. The NPV method is better because it shows the size of the project so you can see how much value a project has not just a percentage. You could have a higher percentage but a much lower value and you would still go for the lower percentage.

WPC has used a discount rate of 15% to evaluate potential projects for the last 10 years. Many in management are correct in thinking that this rate should be evaluated on a much more frequent basis. The current rate of 15% is much too high considering the yield on treasury bonds has declined from 10% to 5% over the last ten years. In order to calculate the correct discount rate we must first determine what their equity and debt ratios are. As you can see in Exhibit1, in order to find the total value of equity we must multiply the number of total outstanding shares of stock times the market value of each share. Completing this calculation shows us that WPC has $12 billion in outstanding equity. WPC also has $2.5 billion in outstanding debt. If you add the debt and equity together we see that WPC has a total of $14.2 billion in outstanding financing. Assuming the 10 year rate of Government Bonds of 4.60% as our risk free rate and using the Capital Asset Pricing Model we find that that WPC’s return on equity is 11.2% (See Exhibit 1). As stated in the case, Worldwide Paper Company has an A bond rating so we can use the 5.78% for their return on debt. Combining all of these variables in the Weighted Average Cost of

f. profitability index (PI) is the present value of future cash flows divided by the initial cost. It’s reciprocal to the cost-benefit ratio. It measures “bang for buck”

If the business was to make an investment on a project that was not right or not profitable the smart thing to do would be to not invest in the project or consider it at all. An investment that does not make any money can be wasteful for the business and make it lose a lot of money in the long run. That is why it is important for those who make the decision to evaluate all of their alternatives, risks, and returns, etc in order to decide on whether or not to reject or accept a project that it might have in mind.

WACC: is a discount rate with minimum acceptable rate that determine if any project would be optimistic for NPV or not. Capital budgeting is the process of assessing the profits for future business projects especially when the funds are limited (Unknown, 2014).

Capital budgeting is a long-term schedule that decides what investment projects to choose. When an option is selected, a company decides where and how to obtain the funds to support its investment and a way of determining the capital structure. A company should make sure it has access to working capital to maintain it operations daily. If this is not available, the company will not be able to maintain it daily operation until

The Company should maximize on cash management by capital rationing on the project accepted. NPV of the project should be implemented as it reflects the time value of money invested in the accepted project. Similarly this can be further elaborated by computation of IRR of both project proposal.

(a) What is the profitability index for the set of cash flows if the relevant discount rate is 10%? (b) What is the profitability index for the set of cash flows if the relevant discount rate is 15%? (c) What is the profitability index for the set of cash flows if the relevant discount rate is 22%?

The project has a positive net present value of $46.59 million. As such, the project should be accepted. The reasoning behind this is that the company should accept any project if the NPV is above 0. The NPV reflects value added to the company. Management, therefore, should pursue any project that adds value to the company and that means pursuing projects with a positive NPV. A positive NPV will increase shareholder wealth, and a negative NPV will reduce shareholder wealth (Baker, 2000).

Net present value can help address the time value of money when comparing projects. Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). The NPV decision rule asserts that all positive NPV projects should be accepted in an unconstrained environment, or if projects are mutually exclusive, the projects with the highest NPV should be accepted.

The Discount Payback Period (DPP) does consider the time value of money. It is computed somewhat like the PB method and the only difference is that DPP method uses the discounted cash flow. As we look at the DPP for Corporation A and Corporation B we see that again Corporation B is less time to pay back the cash flow:

To make the payback period 2 years the annual cash flow should be increased to $ 500000

Decision rule - When there is a mutually exclusive project is to choose one with highest NPV (Acowtancy, 2015). The higher the positive NPV, the more attractive the project (Thompson, August 2015).

Capital budgeting is one of the most important decisions that face a financial manager. There are many techniques that they can use to facilitate the decision of whether a project or investment is worthy of consideration. The four that will be covered within this paper are Payback Rule, Profitability Index, IRR and NPV. Each method has its strength and weaknesses and they will be examined to determine which method is superior to the rest.

An evaluation of capital budgeting will give a concise view of the process management takes to determine the return on a potential investment. After analyzing this concept, the following methods used in making capital budgeting decisions will be discussed: internal rate of return, net present value, and payback period. For each of these three methods, an explanation of the strengths and weaknesses, how they are used, and decisions rules will be given.