There are at least six capital budgeting tools a firm can use in analyzing a capital expenditure. They are: net present value (NPV), internal rate of return (IRR), profitability index (PI), payback period (PB), discounted payback period (DRP), and modified internal rate of return (MIRR). This case study will focus mainly on NPV and IRR, in addition to the remaining four capital budgeting tools.
Net Present Value (NPV)
The NPV of an investment proposal for a project is the same as the” present value of its annual free cash flows less the investment’s initial outlay” (Keown, Martin & Petty, p. 310, 2014). Before calculating the NPV you must first forecast the projected revenue for the life of the project to obtain the net cash flow figures. This involves accountants and analysts crunching numbers based on many factors such as the economy, supply and demand, competition, and how the company plans on carrying out the project (University of Phoenix, 2013). NPV looks at the present value of the benefits minus the present value of the costs. You also need a discount rate; it is normally the cost of capital. The cost of capital is used because a firm wants the project to at a minimum make more than what capital is now costing the firm to run its business.
The rule for NPV is if the value is greater than or equal to zero the project is accepted (Keown, Martin & Petty, p. 310, 2014). After completing a five year projected income statement and a five year projected cash flow from the capital budgeting case study for corporation A and B, this information was used to calculate the NPV for each corporation. Corporation A’s NPV= $2,025 and B’s is NPV= $3,293. Both NPV’s are equal or greater than zero so both projects are a go, but corporation B has a greater NPV, making it a better choice if based on NPV alone (University of Phoenix, 2013). Internal Rate of Return (IRR)