Capital Budgeting Mini Case Essay
Capital Budgeting Mini Case
There are many different methods business owners use to efficiently analyze business investment. One of these effective methods is the calculation of the net present value or NPV. The second most effective method would be the calculations of the internal rate of return or IRR. There are also other useful methods as well, for example, the payback rule and the profitability index. Many business owners use the above procedures to help them in their decision making of acquiring other businesses. “NVP is important to a project because if the cost of the investment is going to be, or is more than the revenue from that project, then it may be more cost effective to shut down the project all together rather than lose more money. If multiple projects are available, then it is wise to first calculate the NPV for each project, choose those that have a positive NPV, and reject the ones that have zero or negative NPVs.
Moreover, the IRR method can be used, and generally, they should provide the same ranking of the projects because the projects with high NPV also tend to have high IRR (Hestwood, Lial, Hornsby, & McGinnis 2010)”. “There are many reasons the IRR is imperative to a company. If the rate of return is insufficient, it means additional cash is out flowing from the company than is inflowing into the company. This could lead to negative working capital. The IRR is imperative for a company to understand, so if necessary, they can afford to finance more activity or if necessary, they then can invest additional money (Hestwood, Lial, Hornsby, & McGinnis 2010)”.
The formula used to calculate the PV is future value times (1/((1+i^n)) = present value. This calculation is useful in investment analysis to assess if an investment with a promised set amount of return in the future will give a net gain in the present value or will only appear to be increasing but containing the same or even less amount when time value of money is considered. For example, FV=$100, with an interest of 7.7% compounded annually and a period of 38 years. Using the formula and substituting the values into it, the equation is obtained: PV = 100 * [1/ (1+0.077)38] = 5.97 dollars
The formula indicates the present value of $100 in 38 years from now given that the interest rate is 7.7% compounded annually is 5.97 dollars. Thus, it also means if an investment promises a return of 100 dollars after 38 years, the interest rate is assumed to be fixed at 7.7%. Considering the effects of time and the value of money, the investor will have a net gain if the required initial investment is lower than 5.97 dollars, a breakeven point when the investment is 5.97 dollars and a loss if the required investment is higher than 5.97 dollars.
In our capital budgeting case scenario, we will recommend acquiring Corporation B because it has higher NPV of $40,251.47 as compared to the Corporation A’s NPV of $20,979.20. In addition, Corporation B has higher IRR of 17% as compared to the Corporation A of 13%.
There are many factors business owners should consider when acquiring other businesses. We believe financial forecasting should be used before the final acquisition decision is made. Financial forecasting is a very useful and an objective decision-making tool regarding the funding requirements of the organization in the future. By using forecasting, this helps the managers or owners plan properly and prioritize between multiple objectives of the firm such as growth, international expansion, cost cutting, research and development, and so on. It also helps to decrease potential failure by knowing and understanding the financial risks.
Financial forecasting is therefore used for predicting realistically how the firm will perform financially in the future. A company uses three basic steps to forecast and project their financial needs correctly. Projecting a specific planning period’s revenue of sale and a company’s expenses are the first steps. During the first step it is important to use a method such as percent of sales, because this method will forecast financial variable of the company. Then we need to evaluate the stages of investment in both current assets and fixed assets to support the estimated sales. Throughout this stage, it is important to calculate the approximate sustainable growth rate.
This rate will be the maximum rate in which sales may grow if the present financial ratio maintained without issuing new equity. The financial manager also needs to establish how the funds will be used in buying inventory, equipment, building, etc. that is capital expenditures. The step after investing in the current and fixed assets is to discover the financing needs of a company during a specific period. Cash budget will play a significant role in this step because it provides and lays out a detailed plan of cash disbursements, cash receipts, and net changes. Moreover, it will identify new needs for any financing.
In this capital budgeting case scenario, one must look at Corporation A’s data, Corporation with a discounted payback period of 4.6 months. This would recover its entire cash outflow by the end of the 5th year. Its cumulative cash inflow of up to the 4th year is -31,688 which is in negative. At the end of the 5th year it is at +20,979 thus, 31688/52668 = .6. Hence, discounted payback period will be 4.6 months. Corporation B has a discounted payback period of 4.24 months. Its cumulative cash inflow of up to the 4th year is -12964, which is in the negative.
At the end if the 5th year it is +40251 thus, 12964/53215 = 24 hence, discounted payback period will be 4.24 months. With that being said, the best choice would be acquiring Corporation B because the payback period is shorter than of Corporation A. Not to mention Corporation B has a higher IRR of 17% compared to Corporation A which has an IRR of 13%. In addition, Corporation B has a higher profitability index of 1.16 compared to that of Corporation A, at 1.08.
Hestwood, D., Lial, M., Hornsby, J., & McGinnis, T. (2010). Quantitative reasoning for business. (custom e-text) Boston, MA: Pearson/Addison-Wesley. Sevilla, A., & Somers, K. (2007). Quantitative reasoning: Tools for today’s informed citizen (1st ed). Emeryville, CA: Key College Publishing.