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Capital Budgeting Integral Projections

2. Capital Budgeting Mini-Case

This is an application of capital budgeting that integrates the projection of a basic cash flow and the computation and analysis of six capital budgeting tools.

Your company is thinking about acquiring another corporation. You have two choices; the cost of each choice is $250,000. You cannot spend more than that, so acquiring both corporations is not an option. The following are your critical data:

a. Corporation A:

1) Revenues = 100K in year one, increasing by 10% each year.

2) Expenses = 20K in year one, increasing by 15% each year.

3) Depreciation Expense = 5K each year.

4) Tax Rate = 25%

5) Discount Rate = 10%

b. Corporation B:

1) Revenues = 150K in year one, increasing by 8% each year.

2) Expenses = 60K in year one, increasing by 10% each year.

3) Depreciation Expense = 10K each year.

4) Tax Rate = 25%

5) Discount Rate = 11%

You must compute and analyze items (a) through (h) using a Microsoft Excel spreadsheet. Make sure that all calculations can be seen in the background of the applicable spreadsheet cells. In other words, leave an audit trail so that others can see how you arrived at your calculations and analysis. Items (i), (j), and (k) should be submitted in Microsoft Word.

c. A 5-year projected income statement

d. A 5-year projected cash flow

e. Net Present Value

f. Internal Rate of Return

g. Payback Period

h. Profitability Index

i. Discounted Payback Period

j. Modified Internal Rate of Return

k. Based on items (a) through (h), which company would you recommend acquiring?

l. In a memo, define, analyze, and interpret the answers to items (c) through (h). Present the rationale behind each item and why it supports your decision stated in item (i). Also, attempt to describe the relationship between NPV and IRR. (Hint: The key factor here is the discount rate used.) In this memo, explain how you would analyze projects differently if they had unequal projected years (i.e., if Corporation A had a 5-year projection and Corporation B had a 7-year projection).

Solution Preview

Define, analyze, and interpret the answers to items (c) through (h). .
Present the rationale behind each item and why it supports your decision stated in item (i). Also, attempt to describe the relationship between NPV and IRR.

Several different procedures are available to analyze potential business investments. Some concepts are better than others when it comes to reliability but all provide enough information to get the general scope of the investment. The five procedures that provide useful information are the Net present Value (NPV), the Payback Rule, the Average Accounting Return (AAR), the Internal Rate of Return (IRR), and the Profitability Index (PI). These procedures will help rank the projects from the greatest investment to the worst.
First, the most important concept of evaluating these investments is the NPV. NPV is defined as the difference between an investment's market value and its cost. It is only a good investment if it makes money for the company so a positive NPV will be needed. The projects can be ranked from the most positive NPV to the lowest to determine profitability. This quantitative ranking method is the best to use due to its consideration of the time value of money and its more accurate breakdown of value.
COMMENTS: NPV is a discounted cash flow technique, which explicitly recognize the time value of money. It is defined as the difference between the present value of cash inflow and cash outflows.
In our case we will choose Corporation B as it has higher NPV of $40251 as compared to the Corporation A's NPV of $20979.
Second, the IRR is the next closest alternative to the NPV calculations; therefore it is next in line as far as a method to calculate for investments. The IRR is the discount rate that makes the NPV of an investment zero. An investment should be accepted if it is higher than the required return; if it is lower, the project is not acceptable. The IRR can be a problem if cash flows are not conventional or when in this case with multiple projects to compare, the IRR can be misleading and not provide the actual best investment. With mutually exclusive investment decisions, it is best to choose the ...

Solution Summary

The solution examines capital budgeting for integral projections. The solution calculates a 5-year projected income statement, a 5 year projected cash flow, net present value, internal rate of return, payback period, profitability index, discounted payback period and modified internal rate of return.

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