Capital Budgeting

Full Answer Section

           

• Depreciation is not a cash expense and is therefore excluded from the cash flow analysis.

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Capital Budgeting Computations

   

1. Net Present Value (NPV)

  The NPV is a measure of the profitability of an investment. It calculates the present value of all future cash flows and subtracts the initial investment. A positive NPV indicates that the project is expected to be profitable, while a negative NPV suggests it will result in a loss.

• Project Alpha:
  • NPV=((1+0.10)1$150,000​+(1+0.10)2$150,000​+(1+0.10)3$150,000​+(1+0.10)4$150,000​+(1+0.10)5$200,000​)−$500,000
  • $NPV=\$593,598-\$500,000=\$93,598$
• Project Beta:
  • NPV=((1+0.10)1$200,000​+...+(1+0.10)6$200,000​)−$700,000
  • $NPV=\$871,059-\$700,000=\$171,059$
• Project Gamma:
  • NPV=((1+0.10)1$100,000​+(1+0.10)2$150,000​+(1+0.10)3$250,000​+(1+0.10)4$300,000​+(1+0.10)5$200,000​)−$600,000
  • $NPV=\$751,200-\$600,000=\$151,200$

Analysis: All three projects have a positive NPV, indicating that they are all potentially profitable. However, Project Beta has the highest NPV at $171,059, suggesting it would add the most value to the company in today's dollars.

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2. Internal Rate of Return (IRR)

  The IRR is the discount rate at which the NPV of a project becomes zero. A project's IRR must be greater than the company's cost of capital (10%) to be considered acceptable. The project with the highest IRR is generally preferred.

• Project Alpha: The IRR is approximately 15.24%.
• Project Beta: The IRR is approximately 17.58%.
• Project Gamma: The IRR is approximately 16.32%.

Analysis: All three projects have an IRR greater than the 10% cost of capital, making them viable investments. Consistent with the NPV analysis, Project Beta has the highest IRR, indicating it provides the highest return relative to its cost.

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3. Payback Period

  The payback period is the time it takes for a project to recover its initial investment. While it does not consider the time value of money, it is a useful metric for assessing the liquidity and risk of an investment. Projects with shorter payback periods are often preferred.

• Project Alpha:
  • $500,000 (initial cost) / $150,000 (annual cash flow) = 3.33 years
• Project Beta:
  • $700,000 (initial cost) / $200,000 (annual cash flow) = 3.5 years
• Project Gamma:
  • Year 1: $100,000
  • Year 2: $100,000 + $150,000 = $250,000
  • Year 3: $250,000 + $250,000 = $500,000
  • Year 4: $500,000 + $300,000 = $800,000
  • The payback period is between year 3 and 4. Specifically: 3 years + ($100,000 / $300,000) = 3.33 years

Analysis: Project Alpha and Project Gamma have the shortest payback period, which is 3.33 years. This indicates they will recoup their initial investment faster than Project Beta, which takes 3.5 years.

Sample Answer

           

Capital Budgeting Analysis: Three Proposed Investment Projects

  This report utilizes capital budgeting tools to evaluate three proposed investment projects—Project Alpha, Project Beta, and Project Gamma—and recommends the project that will deliver the most value to the company. The analysis will focus on key financial metrics, including Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period.

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Project Descriptions and Assumptions

  Project Alpha: Involves the expansion of an existing product line. It requires an initial investment of $500,000 and is projected to generate annual cash inflows of $150,000 for the next five years. The salvage value is estimated to be $50,000. Project Beta: Represents an investment in new, state-of-the-art machinery to improve operational efficiency. The initial cost is $700,000, and it is expected to produce annual cash inflows of $200,000 for six years. The salvage value is negligible. Project Gamma: A high-risk, high-reward venture into a new market. It requires an initial investment of $600,000, with projected cash inflows of $100,000 in year one, $150,000 in year two, $250,000 in year three, $300,000 in year four, and $200,000 in year five. Key Assumptions:

• The company's cost of capital (discount rate) is 10%.
• All cash flows are received at the end of each year.
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