Capital Budgeting: Key Financial Metrics

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On Your Mark is considering purchasing new manufacturing equipment that costs $1,300,000 and is expected to improve cash flows by $500,000 in year 1, $350,000 in year 2, $475,000 in year 3, $450,000 in year 4, and $300,000 in year 5.

Key financial metrics for this capital budgeting project have been calculated and provided by the Finance department (see below). A 14% rate of return and a payback period of less than five years are required for the project. These key metrics must include (1) payback period, (2) net present value, and (3) internal rate of return. (Use 6% as the weighted average cost of capital).

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
(1,300,000) 500,000 350,000 475,000 450,000 300,000

PV 438,596 269,314 320,611 266,436 155,811

NPV 150,768

IRR 19%

payback 800,000 450,000 (25,000) (475,000) (775,000)

MIRR 17%

In a memo to the CFO, discuss the metrics and make a recommendation whether to accept or reject the project.

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Solution Preview

Capital budgeting involves taking decisions about the long term assets mix of the organization. Let us discuss each of the capital budgeting tools:

Net Present Value (NPV):
As per investopedia "Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield."

If a prospective investment has a positive net present value (i.e., the present value of cash inflows exceeds the present value of cash outflows), then it clears the minimum cost of capital and project can be accepted. On the other hand, if an ...

Solution Summary

This response provides the required steps to compute the key financial metrics for the capital budgeting project.

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