Capital Budgeting Essay
On this paper the reader will be able to find the rationale in the analysis of a specific capital budgeting case study. Definitions along with explanations related to capital budgeting such as Internal Rate of Return (IRR) and Net Present Value (NPV) will be provided and debriefed. It is extremely relevant to mention that capital budgeting allows the companies to analyze one or more projects to decide eventually which project or piece of equipment would be most profitable or suitable (economically), according to the needs and the capacities the company has.
Before entering into the analysis a little further and into the company chosen let us define what Net Present Value really is. According to Business Dictionary (2011) the definition of NPV is “The difference between the present value of the future cash flows from an investment and the amount of investment. Present value of the expected cash flows is computed by discounting them at the required rate of return.” “NPV is considered as one of the two discounted cash flow techniques, the other one is the Internal Rate of Return”.
There are different types of net present values such as the negative net present value (worse return), the positive present value (better return), and the zero net present value that basically means that the original amount is repaid at the rate established. We mentioned earlier that the other discounted cash flow technique was the IRR, let us define it so we can see the relation. According to www.princeton.edu (2013) “The Internal Rate of Return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments”.
In more specific words it is the effective rate (interest) where the net present value of costs of the investments equals the net present value of the benefits of this investment. Both discounted cash flows techniques are used to make comparisons in flows of income that varies over time. Internal Rates of Return are frequently and commonly used to evaluate the desirability of investments or projects. The main difference between the IRR, and the NPV is that the IRR is a rate that let the companies know the efficiency and quality of the investment made while the NPV solely focuses on the value of that investment. Therefore, we may assume that they are linked but they do not have the same purpose.
After analyzing the projected income of Corporation A and Corporation B it is better to invest in Company B. Income from Operations in Corporation A is greater than Corporation B by $233 at the end of the five-year forecast but still Corporation B generated more revenues. The NPV of Corporation B at the end of the five-year projection is almost twice as the one that the Corporation A ended with. Therefore, in order to invest we may say that Corporation B has more capital to do so. The depreciation expense makes a vast difference at the end of the five-year projection since what Corporation A does not have as revenue in comparison with Corporation B has it in the difference of the depreciation expense which is twice in Corporation B ($10,000).
We may say that Income from Operations, Income Tax, and Net Income is almost the same. There is only a slight difference in the IRR between them of 3.9% that represents a difference at the end of the projection among them of $87.19 but still if it is analyzed thoroughly it is not the same to have an effective IRR of 16.9 out of 40K than from 20K at the end of a five-year projection another reason why the Corporation B was chosen. Furthermore, in a cash flow projection of five years Corporation A has less net cash provided at the end, but we also have to mention that Corporation B had twice as many depreciation expense values (as mentioned earlier) than Corporation A but the cash payment from income taxes in Corporation B was greater. In conclusion if the company relies only on the NPV and the IRR of each corporation to make the proper investment they should choose Corporation B since it provides a better effective rate of return and more capital to invest.
Business Dictionary.com. (2013). Retrieved from http://www.businessdictionary.com/definition/net-present-value-NPV.html
www.princeton.edu. (2013). Retrieved from
University of Phoenix Capital Budgeting Case (2013). Retrieved from https://newclassroom3.phoenix.edu/Classroom/#/contextid/OSIRIS:42920011/context/co/view/activityDetails/activity/fbe198e8-2920-493d-bd44-1825fa744ef6/expanded/False/focus-cmt/none