Capital budgeting techniques to maximize share wealth
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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. Brealey, R.A., Myers, S.C., & Allen, F. (2005). Principles of corporate finance, 8th Edition. McGraw−Hill. Retrieved June 2014 from http://jcooney.ba.ttu.edu/fin3322/Brealey%20Files/Appendix%20A%20-%20Present%20Value%20Tables.pdf (Please use Table 1)
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.
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Solution Summary
Different capital budgeting techniques are used to evaluate a project and advantages and disadvantages of each are listed.
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CASH FLOW ESTIMATION AND CAPITAL BUDGETING
Introduction
Capital budgeting is a process of decision making for investing in long term assets. Capital budgeting techniques are frequently used by companies to check for feasibility of new projects. Only if the project is viable in terms of costs and benefits achieved, it is executed. There are different capital budgeting techniques such as net present value, internal rate of return, modified internal rate of return, payback period, profitability index, and accounting rate of return. Usually a combination of more than one technique is used to determine if the project would be financially viable for the company. We would be using capital budgeting techniques which include net present value, internal rate of return and payback period and also modified internal rate of return and discounted payback period. Finally, we would list advantages and disadvantages of each of the techniques used and make a recommendation on whether the project should be accepted or rejected.
Capital Budgeting Techniques
1. Net Present Value (NPV)
Based on NPV calculations, the project has a positive NPV of $68,064,427. The project should be selected as it has positive NPV.
2. Payback Period
Payback period focuses on the time required to recover the initial ...
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