Applying Various Capital Budgeting Methodologies. The objective of a firm is to
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Question
Applying Various Capital Budgeting Methodologies.
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. Online Learning Center. (n.d.) Present and Future Value Tables. Retrieved from http://highered.mheducation.com/sites/0072994029/student_view0/present_and_future_value_tables.html 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.
Explanation / Answer
NPV Method Year Cash Flow P.V 0 -125000000 -125000000 1 12000000 10666666.67 2 3500000 2765432.099 3 89750000 63034293.55 4 115000000 71793933.85 5 120000000 66591474.88 NPV 89851801.05 NPV is less than the initial Outflow,so Project should not be accepted. Payback Method Investment= $ 125,000,000.00 Year Cash Flow Cumulated cash flow 1 $ 12,000,000.00 $ 12,000,000.00 2 $ 3,500,000.00 $ 15,500,000.00 3 $ 89,750,000.00 $ 105,250,000.00 4 $ 115,000,000.00 $ 220,250,000.00 5 $ 120,000,000.00 $ 340,250,000.00 If the company has a requirement that project are paid back within 3 years ,the company should not accepted the project. Payback Period 3.172 Discounted Payback Period Initial Investment= $ 125,000,000.00 Year Cash Flow P.V (12.5% @5 year) Cumulative Cash Flow 1 $ 12,000,000.00 $ 10,666,666.67 $ 10,666,666.67 2 $ 3,500,000.00 $ 2,765,432.10 $ 13,432,098.77 3 $ 89,750,000.00 $ 63,034,293.55 $ 76,466,392.32 4 $ 115,000,000.00 $ 71,793,933.85 $ 148,260,326.17 5 $ 120,000,000.00 $ 66,591,474.88 $ 214,851,801.05 Discounted Payback Period= 3.676 Project with a higher cash flow in later years,in the year 4 and 5 ,so company should not accept the project. IRR Year Cash Flow 0 $ (125,000,000.00) 1 $ 12,000,000.00 2 $ 3,500,000.00 3 $ 89,750,000.00 4 $ 115,000,000.00 5 $ 120,000,000.00 IRR= 30% On thes basis of IRR ,the company should accept the project because its IRR> cost of Capital MIRR= Year Cash Flow 0 $ (125,000,000.00) 1 $ 12,000,000.00 2 $ 3,500,000.00 3 $ 89,750,000.00 4 $ 115,000,000.00 5 $ 120,000,000.00 Cost of Capital 12.50% IRR 30% MIRR= 30% On thes basis of MIRR ,the company should accept the project because its MIRR> cost of Capital Advantages NPV Payback Method IRR It considers cash inflows received in the whole life of the project. The Computation & use of this method is Quite Simple. In this method full life of the project is taken into consideration. It consider time value of money. It is generally used by those firm who are facing problem of cash shortage & finance their project throug loans It is not based on assumed cost of capital If this method is followed wealth of the shereholder is maxmized. Project in which greater risk ,choose those project having shorter payback period It is consistent with the objective of maximising shareholder wealth.
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