Applying Various Capital Budgeting Methodologies
The objective of a firm is to maximize shareholder wealth. The Net Present Value (NPV) method is one of the useful methods that help financial managers to maximize shareholders’ wealth.
Suppose the company that you selected for the Module 1 SLP is considering a new project that will have an initial cash outflow of $125,000,000. The project is expected to have the following cash inflows:
Year Cash Flow ($)
1 2,000,000
2 3,500,000
3 13,500,000
4 89,750,000
5 115,000,000
6 120,000,000
If the project’s cost of capital (discount rate) is 12.5%, what is the project’s NPV? Should the project be accepted? Why or why not?
You may use the following steps to calculate NPV:
1. Calculate present value (PV) of cash inflow (CF)
PV of CF = CF1 / (1+r)^1 + CF2 / (1+r)^2 + CF3 / (1+r)^3 + CF4 / (1+r)^4 + CF5 / (1+r)^5 + CF6 / (1+r)^6
Where the CFs are the cash flows and r = the project’s discount rate.
2. Calculate NPV
NPV = Total PV of CF – Initial cash outflow
or -Initial cash outflow + Total PV of CF
r = Discount rate (12.5%)
If you do not know how to use Excel or a financial calculator for these calculations, please use the present value tables.
Online Learning Center. (n.d.) Present and Future Value Tables. Retrieved from http://highered.mheducation.com/sites/0072994029/student_view0/present_and_future_value_tables.html
Also, consider reviewing http://www.tvmcalcs.com for financial calculator tutorials.
Besides NPV, there are other capital budgeting methodologies including the regular payback period, discounted payback period, profitability index (PI), internal rate of return (IRR), and modified internal rate of return (MIRR). These methodologies don’t necessarily give the same accept/reject decisions as NPV.
If the firm has a requirement that projects are paid back within 3 years, would the project be accepted based off the regular payback period? Why or why not? Would the project be accepted based off the discounted payback period? Why or why not?
What is the project’s internal rate of return (IRR)? Based off IRR, should the project be accepted? Why or why not? Recall the project’s cost of capital is 12.5%. What is the project’s modified internal rate of return (MIRR)? Based off MIRR, should the project be accepted? Why or why not?
What are the advantages/disadvantages of NPV, regular payback, discounted payback, PI, IRR, and MIRR? Present these advantages/disadvantages in a table.
SLP Assignment Expectations
You are expected to:
- Describe the purpose of the report and provide a conclusion. An introduction and a conclusion are important because many busy individuals in the business environment may only read the first and the last paragraph. If those paragraphs are not interesting, they never read the body of the paper.
- Answer the SLP Assignment question(s) clearly and provide necessary details.
- Write clearly and correctly—that is, no poor sentence structure, no spelling and grammar mistakes, and no run-on sentences.
- Provide citations to support your argument and references on a separate page. (All the sources that you listed in the references section must be cited in the paper.) Use APA format to provide citations and references.
- Type and double-space the paper.
Whenever appropriate, please use Excel to show supporting computations in an appendix, present financial information in tables, and use the data computed to answer follow-up questions. In finance, in addition to being able to write well, it’s important to present information in a professional manner and to analyze financial information. This is part of the assignment expectations and will be considered for grading purposes.
