Capital Budgeting Essay
697 WordsNov 11th, 20063 Pages
Strident Marks can utilize the capital budgeting to evaluate their proposed long-term investments. Once we have identified a list of potential investment projects, the next step in the process will be to estimate the expected cash flows and risk of each project. Based on these estimates, we can evaluate each project and decide which set of projects are the best for Strident Marks to undertake. The primary decision methods used to evaluate the projects will be payback, net present value, and internal rate of return(Gallagher, 2003).
The simplest capital budgeting method is the payback method. The analyst must calculate the number of years it will take to recoup the project's initial investment (Gallagher, 2003). This is done by adding…show more content…
The equation to calculate NPV is as follows:
where CFt is the cash flow at time t, k is the appropriate discount rate. Our project can be acceptable if the NPV is greater than or equal to zero and unacceptable otherwise. An NPV profile that shows the NPV for various discount rates will show how sensitive the project's NPV is to the discount rate assumption. Taking into account our Project's key financial data, we can compute the NPV as follows:
Net Present Value Project Discount: 10% Time Strident Marks Present Value
0 -10,000.00 -$10,000
1 $7,500.00 $6,818
2 $7,500.00 $6,198
3 $7,500.00 $5,635 PV_Benefits $18,651 Net Present Value $8,651
The problem with the NPV method is that this method will be difficult to explain to the stakeholders who are not financially literate. Another problem that we will face using this method is that NPV is calculated in dollars, instead of percentages (Gallagher, 2003). Many stakeholders prefer to work with percentages to easily compare the project with other alternatives.
The third method we can use to gauge the worth of its upcoming project is by using Internal rate of return (IRR). IRR is the rate of return the project will earn, given its incremental cash flows and initial investment. It is the discount rate that makes the project's NPV = 0. IRR is calculated by setting the NPV to zero and solving for the discount rate (Gallagher, 2003).
By applying the current Project Discount rate
Essay Capital Budgeting
935 Words4 Pages
Capital Budgeting The city engineers presented city council members with two projects that require large capital outlays. However, the economic downturn makes implementation of both projects impossible with current budget restraints. Therefore, the city council decided to conduct a cost benefit analysis to determine the most cost effective project. While neither project met all the requirements, data analysis determined that Option B was the best choice. However, city engineers pushed back stating that both projects are vital to the city. Consequently, it was necessary to consider an alternative solution. The proposal below provides a detailed explanation of all options including an alternative solution.
Explanation: Option A and…show more content…
The new capital cost for Option A is $-3,580,000.00 and for Option B is $-3,150,000.00. The net present value for Option A with a discount rate of 12 percent, capital cost of $-3,580,000.00, and benefits generated a negative net present value. While Option B with the capital costs $-3,150,000.00, a discount rate of 12 percent and benefits equaled a net present value of $763,122.00.
Project Justification: Option B While neither option meets all the criteria, Option B is the most cost-effective and efficient option of the two. Additionally, Option B's higher internal rate of return of nineteen percent provides the best re-investment opportunity for the future. Research shows that the internal rate of return "is and has been a popular measure of worth for purposes of project evaluation. It defines the return achieved by an investment (or true cost of a loan) and can often be viewed as a measure of efficiency" (Hartman & Schafrick, 2004, p. 139). Additionally, Option B has a positive net present value, while Option A has a negative net present value. In addition, the payback period for Option B is five years and the payback period for Option A is 7.475 years. In addition, the payback period for Option B is outside the city council's 2.75 years requirement. The long payback period should not disqualify Option B from city council members' decision-making process. Empirical tests show that "the net present value method is usually a better guide in the