Capital management

Capital management

Part 1. (a) Capital Budgeting Practice Problems

Capital Budgeting
Year/s Future value interest rate Step 1 Present value Totals
0 400000 0 1 400000
1 100000 0 1 100000
2 120000 0 1 120000
3 850000 0 1 850000
Total 1470000
0 400000 2 1 400000
1 100000 2 1.02 98039.21569
2 120000 2 1.0404 115340.2537
3 850000 2 1.061208 800973.9844
Total 1414353
0 400000 6 1 400000
1 100000 6 1.06 94339.62264
2 120000 6 1.1236 106799.5728
3 850000 6 1.191016 713676.3906
Total 1314816
0 400000 11 1 400000
1 100000 11 1.11 90090.09009
2 120000 11 1.2321 97394.69199
3 850000 11 1.367631 621512.6741
Total 1208997

 

Internal rate of return (IRR) is the rate of interest at which NPV (Net Present Value) is zero of both the positive and negative cash flows from an investment. Internal rate of return is used to analyze the profitability of an investment. If the internal rate of a new investment is in excess of a required rate of return, then that’s a good investment but if the IRR goes below the needed IRR then the project is not good and should be rejected  (Brealey, Myers, and  Allen, 2006).

 

 

years Pv tables Cash Flow
0 0 400000 0
1 0.952 100000 95200
2 1.859 120000 223080
3 2.728 850000 2318800
IRR for the project 2637080

 

Internal rate of return = 2637080

http://hotelmule.com/html/57/n-2757-3.html  ( for PV tables)

NPV/Discount Rates

The graph does not cross the x-axis it justs runs parallel to it.

 

 

 

 

 

Part 1 (b)

Capital Budgeting

Year/s Future value interest rate Step 1 NPV Totals
0 815000 1 1 815000
1 141000 1 1.01 139603.9604
2 320000 1 1.0201 313694.7358
3 440000 1 1 440000
Total 1708299
0 815000 4 1 815000
1 141000 4 1.04 135576.9231
2 320000 4 1.0816 295857.9882
3 440000 4 1.124864 391158.3978
Total 1637593
0 815000 10 1 815000
1 141000 10 1.1 128181.8182
2 320000 10 1.21 264462.8099
3 440000 10 1.331 330578.5124
Total 1538223
0 815000 18 1 815000
1 141000 18 1.18 119491.5254
2 320000 18 1.3924 229819.0175
3 440000 18 1.643032 267797.584
Total 1432108

 

 

 

 

 

NPV/Discount Rates

The graph steeps sharply but eventually runs parallel to the X-axis.

  1. C) A project requiring a $4.2 million investment has a profitability index of 0.94. What is its net present value?

Profitability = 0.94  Fv = $ 4.2 million

NPV = 0.94 * $4.2 million = $ 3.948 million.

Part 2

Which method do you think is the better one for making capital budgeting decisions – IRR or NPV?
Defend your answer with references to the background materials

In capital budgeting, different approaches are used to analyze and evaluate a given project with each approach analyzing its advantages and disadvantages. With everything constant, internal rate of return (IRR) and the net present value (NPV) mostly have the same results. However in some projects NPV is more effective than NPV in discount cash flows. IRR utilizes a single discount rate to analyze and evaluate each investment. There are some instances where a single discount rate does not apply. IRR doesn’t account for any changing discount rates, it’s not suitable for longer projects with varying discount rates. Also where there are negative and positive cash flow the IRR doesn’t apply.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References

Richard A. Brealey, Stewart C. Myers and Franklin Allen. (2006) Principles of Corporate Finance, 8th Edition. McGraw-Hill/Irwin.

http://hotelmule.com/html/57/n-2757-3.html

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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