# Capital Budgeting Technique Effects: NPV, IRR, & Simple Payback

Summarize the resulting NPV explaining the effects of cost of capital and a very complete analysis of the 3 capital budgeting techniques of NPV, IRR, and simple payback. How and why are these techniques used in strategic financial management?

Info:

Given the information for Proposal A, which is the building of a new factory, only the incremental cash flows are needed for the net present value analysis. The incremental cash flows are as follows:

1. Sales of $3 million a year which translates to an increase in gross margin by $150,000 given a 5% gross margin

2. Initial investment of $10 million this is the cost of building the new factory

3. Salvage value at the end of the project's life of $14 million

Given a 10% weighted average cost of capital, the following table shows the NPV computation for this project.

Year Cash Flow PV Factor Present Value

0 (10,000,000) 1.0000 (10,000,000)

1 150,000 0.9091 136,364

2 150,000 0.8264 123,967

3 150,000 0.7513 112,697

4 150,000 0.6830 102,452

5 150,000 0.6209 93,138

6 150,000 0.5645 84,671

7 150,000 0.5132 76,974

8 150,000 0.4665 69,976

9 150,000 0.4241 63,615

10 14,150,000 0.3855 5,455,438

Net present value (3,680,709)

As demonstrated in the present value table above, the net present value of the capital project is a negative $3,680,709. This means that the project will result in a decline in the wealth of the company's stockholders, as a result a violation of the wealth maximization concept.

What is more, at the end of the life of the asset, or on the 10th year, the cash flows included the $14 million expected salvage value from selling the factory. Also, the present value factor was computed by the following formula: PV factor = 1/(1 + r)^t Whereas, r = cost of capital and t = year. The present value of each of the cash flows was computed by multiplying the cash flow column with the present value column.

Assuming that the weighted average cost of capital is 6%, then the net present value, as computed below, is a negative $1,078,460 which is much higher than the NPV at a 10% cost of capital.

Year Cash Flow PV Factor Present Value

0 (10,000,000) 1.0000 (10,000,000)

1 150,000 0.9434 141,509

2 150,000 0.8900 133,499

3 150,000 0.8396 125,943

4 150,000 0.7921 118,814

5 150,000 0.7473 112,089

6 150,000 0.7050 105,744

7 150,000 0.6651 99,759

8 150,000 0.6274 94,112

9 150,000 0.5919 88,785

10 14,150,000 0.5584 7,901,286

Net present value (1,078,460)

A 12% cost of capital shows an NPV of a negative $4,644,841. This is much lower than the net present value at a weighted cost of capital of 6% and 10%.

Year Cash Flow PV Factor Present Value

0 (10,000,000) 1.0000 (10,000,000)

1 150,000 0.8929 133,929

2 150,000 0.7972 119,579

3 150,000 0.7118 106,767

4 150,000 0.6355 95,328

5 150,000 0.5674 85,114

6 150,000 0.5066 75,995

7 150,000 0.4523 67,852

8 150,000 0.4039 60,582

9 150,000 0.3606 54,092

10 14,150,000 0.3220 4,555,921

Net present value (4,644,841)

#### Solution Preview

Risk in capital budgeting may be defined as the variation of actual cash flows from the expected cash flows. (Resources, 2010)

One should estimate following:

1) Cash flows in the beginning of the project in terms of Initial investment, working capital & preliminary expenses

2) Annual Operating cash flows in terms of cash revenues, adjustment of working capital and cash expenses.

3) Terminal cash flow in terms of salvage value and recovery of working capital

Capital budgeting involves taking decisions about the long term assets mix of the organization. One uses following tools for analyzing a project:

1) NPV

2) Payback

3) IRR

4) MIRR

NET PRESENT VALUE: The net present value (NPV) method offsets the present value of an investment's cash inflows against the present value of the cash outflows. If a prospective investment has a positive net present value (i.e., the present value of cash inflows exceeds the present value of ...

#### Solution Summary

This solution discusses the effect of capital budgeting techniques, and completes an analysis of NPV, IRR and simple payback.