The conference on evaluating capital projects has been very helpful. You have re
ID: 2383454 • Letter: T
Question
The conference on evaluating capital projects has been very helpful. You have received a significant amount of information and multiple projects to evaluate to hone your skills. To adequately teach Grammy and the board you will need to answer several questions about the capital-budgeting process. You will do this in a business memo that is no more than four pages long.
Provide an evaluation of two proposed project, both with a 5-year expected lives and identical initial outlays of $110,000. Both of these projects involve additions to a highly successful product line, and as a result, the required rate of return on both projects has been established at 12 percent. The expected free cash flows from each project are as follows:
Project A
Project B
Initial outlay
-$110,000
-$110,000
Inflow year 1
20,000
40,000
Inflow year 2
30,000
40,000
Inflow year 3
40,000
40,000
Inflow year 4
50,000
40,000
Inflow year 5
70,000
40,000
In evaluating these projects, please respond to the following question:
Why is the capital-budgeting process so important?
Why is it difficult to find exceptionally profitable projects?
What is the payback period on each project? If the organization imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?
What are the criticisms of the payback period?
Determine the NPV for each of these projects. Should they be accepted?
Describe the logic behind the NPV.
Determine the PI for each of these projects. Should they be accepted?
Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
What would happen to the NPV and PI for each project if the required rate of return increased? If the required rate of return decreased?
Determine the IRR for each project. Should they be accepted?
How does a change in the required rate of return affect the project’s internal rate of return?
What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?
Project A
Project B
Initial outlay
-$110,000
-$110,000
Inflow year 1
20,000
40,000
Inflow year 2
30,000
40,000
Inflow year 3
40,000
40,000
Inflow year 4
50,000
40,000
Inflow year 5
70,000
40,000
Explanation / Answer
1.Why is the capital-budgeting process so important?
Ans. Capital budgeting is a step by step process that businesses use to determine the merits of an investment project. The decision of whether to accept or deny an investment project as part of a company's growth initiatives, involves determining the investment rate of return that such a project will generate. However, what rate of return is deemed acceptable or unacceptable is influenced by other factors that are specific to the company as well as the project. For example, a social or charitable project is often not approved based on rate of return, but more on the desire of a business to foster goodwill and contribute back to its community.
Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are that the business will have little chance of surviving in the competitive marketplace.
2. Why is it difficult to find exceptionally profitable projects?
Ans. It is hard to find extremely profitable projects, because it is hard to keep competition out. Profitability attracts competition, and unless a company can set up barriers to entry successfully, competition will drive the profit margin down to the required rate of return.
3. What is the payback period on each project?
Project 1 -
comulative p-2
Payback period of project 1 = 3 +50000/140000 = 3.35year
Payback period of project 2 = 2 + 40000/120000 = 2.33year
So project 2 is more benifitable and short pay-back
4. What are the criticisms of the payback period?
The major criticisms of payback methods are:
The method is ignorant of present value of money. So, whether you assume that you will get your money back in some n installments, say n,spread evenly over n years or nx amount at the end of the period, the payback period will be the same. Let me illustrate this:
It also discards any cash inflows after the initial investment has been recovered and hence, cannot measure profitability in any way. So, there is no way we can make any decision based on this measure. At best, this is just a theoretical measure of the repayment period, without any real use. At worse, a waste of time.
5. Determine the NPV for each of these projects.
According to this aproch project 2 is acceptable.
he NPV approach, or Net Present Value, was called ‘fictitious capital’ by socialist Karl Marx. It is the sum of the present values (PVs) of individual cash flows. When all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price. NPV uses the value of money over time to appraise long-term projects, measuring the excess or shortfall of cash flows. All, irrelevant or relevant, have a potential to interfere, so all flows are used to calculuate the NPV, which are added to a discount rate or discount curve and outputs a price; indeed, bond trading finds a yield through the converse process, taking a sequence of cash flows and a price as input and inferring as output a discount rate.
6.Determine the PI for each of these projects.
PI = P.V of cash in-flow/PV of cash out-flow
P1 = 141,730 / 110 000 = 1.29
P2 = 144,180 / 110,000 = 1.31
P2 is best,other wise both are acceptable because both prtoject PI is grater than 1.
7.Would you expect the NPV and PI methods to give consistent accept/reject decisions?
Yes, The PI and NPV always give the same decisions to accept or reject the projects. The Project's PI will be greater than 1.00 if the NPV is positive and PI will be less than 1.00 if the NPV is negative
8. Determine the IRR for each project.
Now IRR of P1 =PV @12% = 141730 -110000 = 31730
PV @30% = 87695 - 110000 = (22305)
IRR = 12% + 31730/54035 * 18% = 12.062%
Now IRR of P2 =PV @12% = 144180 -110000 = 34180
PV @30% = 97416 - 110000 = (12584)
IRR = 12% + 34180/46764 * 18% = 12.062% = 12.131%
yes they are acceptable..
9. How does a change in the required rate of return affect the project’s internal rate of return?.
The Internal Rate of Return, or IRR, is not affected by the changing in cost of capital. A change in the cost of capital will not, typically, impact on the IRR. IRR is measure of the annualized effective interest rate, or discount rate, required for the net present values of a stream of cash flows to equal zero.
It is important to compare the IRR to the cost of capital when making investment decisions: If the IRR is higher than the cost of capital the project or investment should be valuable, with a positive Net Present Value (NPV), and if the IRR is lower than the cost of capital it should not be undertaken. The NPV is preferred to the IRR to work out stable investments over time. So, whilst a higher cost of capital will not change the IRR, it will lead to fewer investment decisions being acceptable when using IRR as the method of assessing those investment decisions.
Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment; the NPV indicates the value or size of an investment. NPV, unlike when one employs the monorating internal rate of return (IRR), has multiple discount rates to evaluate investments and discount each cash flow in accordance with envisaged conditions. Though IRR is simpler and needs fewer assumptions as to the likelihood of yield, NPV is preferred as it is a more accurate measurement of an investment’s yield.
10. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?
11. What would happen to the NPV and PI for each project if the required rate of return increased? If the required rate of return decreased?
Ans. . Increase in Rate of Return has no effect on Payback Period since we don't discount net cash flows to find Payback Period, so this can't be the answer
2. As Rate of Return Increase the NPV starts to decrease thus this in not the answer either
3. I am not familiar with calculations of AAR thus can't comment on this
4. As Rate of Return increase that decreases each net cash flow when it is discounted at the rate of return thus leading to an increase in Discounted Payback Period so this is not the answer either
5. Profitability Index is the ratio of PV of discounted Net Cash Flows over Initial Cash Outlay, thus when Rate of Return increase that decreases the value of the numerator in the ratio thus leading to a Decrease in Profitability Index
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