# Capital Budgeting Techniques

Colorado Texas New Line Replace Acquire Pollute Cumulative NPV

0 $(1,319,000) $(3,534,000) $(1,582,000) $(4,845,000) $(24,050,000) $(1,650,000)

1 $(233,318) $(583,296) $465,263 $661,105 $4,374,354 $-

2 $525,358 $1,260,859 $766,303 $831,781 $3,146,041 $-

3 $480,408 $1,104,938 $725,619 $710,338 $3,208,962 $2,000,000

4 $443,211 $975,064 $696,446 $628,331 $3,273,141

5 $410,525 $862,103 $383,065 $574,938 $3,338,604

6 $393,172 $786,450 $197,318 $591,281 $3,405,376

7 $372,189 $744,379 $192,677 $608,404 $3,473,484

8 $323,470 $646,834 $158,739 $539,522 $3,542,953

9 $270,306 $486,552 $123,951 $472,081 $3,613,812

10 $235,748 $2,872,825 $279,133 $551,449 $41,652,800

IRR 18.28% 16.69% 30.84% 5.01% 17.24% 6.62%

MIRR 13.65% 13.41% 16.29% 7.69% 14.61% 6.62%

MIN IRR 10% 10% 13% 8% 13% 8%

Payback 2.44 2.59 2.52 1.27 3.04

NPV $2,104,956 $4,939,824 $2,494,182 $3,072,136 $14,217,224 $26,828,321

Using the data from the attached mini case study and financial spreadsheets attached I need to conduct a profitability index. All work on this index should be included in a detailed excel spreadsheet.

Also using the information from the profitability index please provide recommendations on which capital budgeting projects should be selected and give me reasons based on the profitability index.

Please provide as much information as possible.

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#### Solution Preview

Profitability Index

What does it Mean?

Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.

An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:

A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's NPV is less then the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project. This concept is based on Time value of Money.

What Is Time Value?

If you're like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.

But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now: over time you can earn more interest on your money.

Present Value Basics

If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future.

The following are the PI acceptance rules:

Accept the project when PI is greater than one. PI > 1

Reject the project when PI is less than one. PI < 1

May accept the project when PI is equal to one. PI = 1

The project with positive NPV will have PI greater than one. PI less than means that the project's NPV is negative.

2. What criteria might you use to rank the projects? Which quantitative ranking methods are better? Why?

Several different procedures are available to analyze potential business investments. Some concepts are better than others when it comes to reliability but all ...

#### Solution Summary

This illustrates the step by step explanation of various capital budgeting techniques with the help of mini case study.

Capital budgeting techniques to maximize share wealth

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.

•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.