Capital Budgeting Free Essays

Capital Budget Recommendation Anne Adams University of Phoenix Managerial Accounting and Legal Aspects of Business AC543 Sean DAmico August 20, 2012 Abstract This paper will give a comparison between the various preferred capital budgeting evaluation techniques in the corporate business setting. There will be a recommendation given for the Guillermo Furniture Company based on the results of one or more evaluation techniques, which in turn will help direct the financial health of the organization. Corporations are continually striving to improve the financial health of its organization and one strategic way many corporations are doing that is through capital budgeting. We will write a custom essay sample on Capital Budgeting or any similar topic only for you Order Now Capital budgeting involves choices. The choices revolve around projects that will add value to the organization. The projects can include acquiring land, purchasing a truck, or replacing old equipment. Many times, corporations are encouraged to undertake projects that will increase its profitability. The challenge is to find the appropriate evaluation method to bring the intended profitability into reality. The three preferred evaluation methods that many corporations use are net present value, internal rate of return, and payback period. Many corporations often calculate capital budgeting solutions using all three methods. However, each method often produces contradictory results. The net present value method is the most accurate valuation approach to capital budgeting issues (smallbusiness). If a corporation can discount the after tax cash flow by the weighted average cost of capital, managers can determine if the project will be profitable or not. The net present value method reveals exactly how profitable a project will be to the corporation versus the alternative methods (Chen, 2012). With the various evaluation methods, corporations can base the decisions for the future on the results of the evaluation. The net present value method takes the time value of money by discounting an investment’s future return to a present value (Chen, 2012). The thought behind the time value of money concept is that a dollar in hand today is worth more than the same dollar in the future. In capital budgeting decisions, the net present value discount is taken into consideration when the present value of the future return is compared with the present value of the cash outflows on any investment (Mason, 2011). If a corporation, such as Guillermo Furniture, is considering using the net present value method, the return on the investment would show clearly whether it is more than sufficient to increase the financial health of the corporation or not. Another preferred evaluation method is the internal rate of return. The internal rate of return is a discount rate that results from a net present value equal to zero (Mason, 2011). When the internal rate of return is higher than the weighted average cost of capital, it would be considered a profitable endeavor and thus should be pursued (Steven, 2010). A major advantage of the internal rate of return method is that it provides a benchmark for every project (Steven, 2010). This can allow a corporation to compare projects on the basis of the return on invested capital. For example, if Guillermo Furniture’s internal rate of return results higher than the cost of capital, it would be determined that the project is acceptable, and the corporation should move forward on the project. However, if the results are less than the cost of capital, the corporation should abort the project as it would hurt the financial health of the corporation. The final preferred evaluation method used by corporations is the payback period method. The payback period method reveals the amount of time it would take to recover the initial investment on a particular project (smallbusiness). Even though this method is considered preferred, it can result in disappointment for many corporations who value the results (Steven, 2010). The main reason is the results do not factor in the cash flow in its entirety from a certain project, which can skew the overall result of the return on the potential investment (Steven, 2010). When a corporation analyzes this method, it is determined that it results in a break even measure and only measures the economic life of the particular investment revolving around the payback period (Steven, 2010). This method is used mainly as a comparative measure for the net present value and the internal rate of return giving a time frame of recovering the initial investment. After considering the three preferred evaluation methods, it was determined that the net present value method would be the method of choice for the Guillermo Furniture scenario for a couple of reasons. First, the corporation cannot rely solely on the payback method because it does not take into account the entire cash flow for the project. After calculating how much time it would take to recover the initial investment, it was found that it would take more than 50 years, which is unrealistic for capital budgeting purposes. The focus shifted to the second preferred method of internal rate of return. The internal rate of return proved that the return on the investment would only yield 10%. The calculation was based on taking the total investment of $1,354,141. 21 and dividing it on the number of years the profit was expected to continue, which totaled $133,742. 20. The expected rate of return for the project had to be at least 12% for the project to be acceptable. Based on the net present value calculations and taking the required rate of return of 12%, the number of years the profit is expected to continue, which is 5, and the future annual cash flows amount of $26,748. 4, the present value of future cash flows equaled $96,422. 14. The net present value is measured by taking the investment outflow ($96,422. 14) minus the present value of future cash flows ($1,354,141. 21), which equals $1,257,719. 07. By dividing this amount by the investment outflow, the rate of return on investment yields 13%. Therefore, it would be recommended that Guillermo Furniture use the net present valu e method for this project as it would improve the financial health of the corporation. References Chen, J. 2012). ADDING FLEXIBILITY FOR NPV METHOD IN CAPITAL BUDGETING. Global Conference on Business ; Finance Proceedings, 7(2), 49-56. Retrieved from EBSCO host Mason Jr, J. O. (2011). A Couple of Capital Budgeting Techniques using Microsoft Excel. Advances in Management, 4(4), 23-27. Retrieved from EBSCO host Steven, G. (2010). PERFORMANCE OPERATIONS. Financial Management (14719185), 38-42. Techniques in Capital Budgeting Decisions Retrievedwww. smallbusiness. chron. com/techniques-capital-budgeting-decisions-23638. html How to cite Capital Budgeting, Essay examples Capital Budgeting Free Essays Question a What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? Capital budgeting is the process of analyzing potential additions to fixed assets. Capital budgeting is very important to firm’s future because of the fixed asset investment decisions chart a company’s course for the future. The firm’s capital budgeting process is very much same as those of individual’s investment decisions. We will write a custom essay sample on Capital Budgeting or any similar topic only for you Order Now There are some steps involved. First, estimate the cash flows such as interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects. Second is to assess the riskiness of the cash flows. Next, determine the appropriate discount rate, based on the riskiness of the cash flows and the general level of interest rates. This is called project’s required rate of return or cost of capital in capital budgeting. Then, find the PV of expected cash flows and the asset’s rate of return. If the PV of the inflows is greater than PV of outflows (NPV is positive), or if the calculated rate of return (IRR) is higher than the project cost of capital, accept the project. Question b What is the difference between independent and mutually exclusive projects? Between normal and non-normal projects? Independent projects mean a company can select one or both of the projects as long as they meet minimum profitability. This is because the projects do not compete with the firm’s resources. Projects are independent if the cash flows of one are not affected by the acceptance of the other. Read also: â€Å"Support Positive Risk Taking For Individuals† Mutually exclusive projects mean if acceptance of one impacts adversely the cash flows of the other which is firm can select one or another project but not both. This is because projects investments that compete in some way for a company’s resources. When projects are mutually exclusive it means that they do the same job. Normal projects have outflows, or costs, in the first year (or years) followed by a series of inflows. Non-normal projects have one or more outflows after the inflow stream has begun. Inflow (+) Or Outflow (-) In Year 0 1 2 3 4 5 Normal – + + + + + – – + + + + – – – + + + Non-normal – + + + + – – + + – + – + + + – – – Question c 1) Define the term net present value (NPV). What is each project’s NPV? Net present value (NPV) is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. By using financial calculator, the NPV for project L is RM 18,782. 87 while the NPV for project S is RM 19,984. 97. ) What is the rationale behind the NPV method? According to NPV, which project or projects should be accepted if they are independent? Mutually exclusive? The rationales behind the NPV method are; if the NPV is more than zero, the project will be accepted, but the project would be rejected if the NPV is less than zero. The NPV that equal to zero means it is technically indifference whether we accept or not the project, will not gain any benefit or loss. Accor ding to NPV, both projects can be accepted if they are independent because the NPV for both project have positive value of more than zero. But, if they are mutually exclusive, only one project that should be accepted that is project S. This is because the NPV for project S is more higher compared to the NPV for project L. 3) Would the NPVs change if the WACC changed? Yes, the value of NPV would be change if the WACC changed. If the WACC changed to more than 10%, for example 11%, the new NPV would be RM 16,201. 67 for project L and RM 18,268. 01 for project S. If the WACC is 9% which is low than 10%, the new NPV calculated is RM21, 449. 79 for project L and RM 21,747. 85 for project S. So, we can conclude that the lower the WACC, the higher the value of NPV. Question d 1) Define the term internal rate of return (IRR). What is each project’s IRR? Internal rate of return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the intrinsic rate of return. By using financial calculator, the IRR for project L is 18. 13% while the IRR for project S is 23. 56%. 2) How is the IRR on a project related to the YTM on a bond? A project’s IRR is the discount rate that forces the PV of the inflows to equal the cost. This is equivalent to forcing the NPV to equal zero. The IRR is the estimate of the project’s rate of return, and it is comparable to the YTM on a bond. 3) What is the logic behind IRR method? According to IRR, which project should be accepted if they are independent? Mutually exclusive? The logic behind IRR method is; if the IRR is more than WACC, the project will be accepted, but the project would be rejected if the NPV is less than WACC. IRR that equal to WACC means it is technically indifference whether we accept or not the project, will not gain any benefit or loss. According to IRR, both projects can be accepted if they are independent because the IRR for both project have percentage more than the percentage of WACC. But, if they are mutually exclusive, only one project that should be accepted that is project S. This is because the IRR for project S is 23. 56% and it is higher compared to the IRR for project L which only 18. 13%. 4) Would the projects’ IRR change if the WACC changed? No, the IRR would not change if the WACC changed. Question e 1) What is the underlying cause of ranking conflicts between NPV and IRR? In the normal project for the NPV profiles to cross one project must have both a higher vertical axis intercept and a steeper slope than the other. A project’s vertical axis typically depends on the size of the project and the size and timing pattern of the cash flows. For example, for the large projects and with large distant cash flows would expect to have relatively high vertical axis intercepts. The slope of the NPV profile depends entirely on the timing pattern of the cash flows. The long-term projects have steeper NPV profiles compared with short-term projects. So, NPV can only cross in two situations which is when mutually exclusive projects differ in scale or size and when the projects’ cash flows differ in terms of the timing pattern of their cash flows (Project L and S). 2) What is the â€Å"reinvestment rate assumption†, and how does it affect the NPV versus IRR conflict? The underlying cause of ranking conflict is the reinvestment rate assumption. All DCF methods assume that cash flows can be reinvested at some rate. This applies to Project L and S. When we calculated their NPV, we discounted at WACC, 10% which means that we assuming that their cash flows could be reinvested at 10%. IRR assumes that cash flows are reinvested at the IRR. Discounting is the reverse of compounding. Compounding assumes reinvestment and also for the discounting. NPV and IRR are both found by discounting, so they both assume some discount rate. NPV calculation is the assumption that cash flows can be reinvested at the project’s cost of capital while the IRR calculation assumes reinvestment at the IRR rate. 3) Which method is the best? Why? The NPV tells us how much a project contributes to shareholder wealth. The larger the NPV, the more value the project adds, and added value means a higher stock price. Thus NPV is the best selection criteria. A project IRR is the discount rate that forces the PV of the inflows to equal the cost. This is equivalent to forcing the NPV to equal zero. However, NPV or IRR give better ranking is depends on which has the better reinvestment rate assumption. NPV is selected because it used as a substitutes for outside capital hence save the firm cost of outside capital. For most firms, assuming reinvestment at the WACC is more reasonable for the following reasons. If a firm has reasonably good access to the capital markets, it can raise all the capital it needs at the going rate, which in our example is 10%. Since the firm can obtain capital at 10%, if it have investment opportunities with positive NPV, it should take them on and it can finance them at a 10% cost. If a firm uses internally generated cash flows from past periods rather than external capital, this will save it the 10% cost of capital. Thus, 10% is the opportunity cost of the cash flows, and that is the effective return on reinvested funds. However, NPV and IRR usually give the same results to accept or reject the project for independent project. NPV and IRR occurs conflict only when mutually exclusive projects are involved. Question f 1) What is the difference between the regular and discounted payback methods? Payback period is defined as the number of years required to recover the funds invested in a project from its operating cash flows. Discounted payback is the length of time required for an investment’s cash flows, discounted at the investment’s cost of capital to cover its cost. Actually, discounted payback is similar to regular payback except that discounted rather than the raw cash flows are used. 2) What are the two main disadvantages of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions? Discounted payback does consider the time value of money, but it still disregard cash flows beyond the payback period, which is a serious flaw. For example, if mutually exclusive projects vary in size, both payback method can conflict with the NPV, which might lead to a poor choice. However, many firms still use the payback to do the capital budgeting decisions. Payback and discounted payback used as a measure of project’s liquidity and risk. The shorter the payback, other things held constant, the greatest the project’s liquidity. This factor is important for smaller firms that do not have really access to the capital markets. Cash flows expected in the distant future are generally riskier than near-term cash flows, so the payback is used as one risk indicators. How to cite Capital Budgeting, Essay examples Capital Budgeting Free Essays FIN3101 Corporate Finance Practice Questions Topic: Capital Budgeting 1. Marsh Motors has to choose one of two new machines. Machine 1 costs $180,000, has a 3 year life and EBIT of $108,750 per year. We will write a custom essay sample on Capital Budgeting or any similar topic only for you Order Now Machine 2 costs $360,000, has a life of 6 years and EBIT of $122,875 per year. Assume straight line depreciation over the life of the machine. Marsh is a levered firm with a debt equity ratio of 0. 40. The beta of equity is 1. 125 while the beta of debt is 0. 25. The market risk premium is 8 percent and the risk free rate is 5%. The corporate tax rate is 20%. a. b. c. 2. What is the firm’s cost of equity capital? What is the firm’s weighted average cost of capital? Which machine should Marsh purchase? Advanced Technology is considering investing $38m to develop a gold mining site. The average equity beta of similar firms in the industry is 0. 88. The market risk premium is 7% and the nominal risk free rate is 4%. Inflation is expected to be 2%. a. b. Suppose there is a 20% chance of a low output of $2m and an 80% chance of a high output of $6m in the first year. If the output is low in the first year, there is a 70% chance that output will stay at $2m and a 30% chance that output will stay at $4m per year for the rest of the project’s life. However if the output is high in the first year, there is a 80% chance that it will stay at $6m and a 20% chance that it will stay at $3m per year for the rest of the project’s life of 10 years. These are real cash flows. Should the company go ahead with the project? c. 3. The site is expected to yield $6m in gold a year for 10 years. These are real cash flows. Suppose there is a 20% chance of no gold from the site and an empty site means zero cash flow and a complete loss of the $38m investment. What is the NPV of the project? Would your conclusion in (b) be different if the company can abandon the mine for $36m in the event of low yield in the first year? Compute the value of the option to abandon. â€Å"Aviation Biofuel† is considering setting up shop in Singapore. Their plan can be divided into 2 stages. Stage 1: The project requires a test marketing expense of $20m. This test market is expected to last 1 year and there is a 60% chance of success. FIN3101 Page1 Stage 2: If the test market is a success, the firm intends to invest $100m in a plant. The after-tax cash flows will be $66m per year from year 2 to year 5. If the test market is a failure and the firm goes ahead with the investment, the NPV will be -$20m. Assume a cost of capital of 17%. a. Draw the decision tree for this project. b. Estimate the NPV of Aviation Biofuel’s plan. 4. You are asked to evaluate the following wooden cabinet manufacturing project for a corporation. Develop a table showing the annual cash flows and calculate the NPV of this project at an 8% discount rate. All figures are given in nominal terms. 20X6 Physical Production (cabinets) Labor Input (hours) Wood (physical units) 20X7 20X8 3,150 3,750 3,800 26,000 30,000 31,000 550 630 650 The required investment on 12/31/20X5 is $800,000. The firm faces a 34% income tax rate, and uses straight-line depreciation. The salvage value of the investment which will be received on 12/31/X8 will be one fifth of the initial investment. The price of cabinets on 12/31/X5 will be $250 each and will remain constant in the foreseeable future. Labor costs will be $15 per hour on 12/31/X5 and will increase at 5% per year. The cost for the wood will be $200 per physical unit on 12/31/X5 and will increase at 2% per year. Revenue is received and costs are paid at year’s end (i. e. use year-end prices in calculating revenues and costs so, for example, use the 12/31/X6 prices for calculating 20X6 revenues and costs). The firm has profitable ongoing operations so that any losses for tax purposes from the project can be offset against these. . Consider a project to supply Honda with 38,000 tons of machine screws annually for automobile production. You will need an initial $1,596,000 investment in threading equipment to get the project started; the project will last for 6 years. The accounting department estimates that annual fixed costs will be $456,000 and that variable costs should be $220 per ton; accounting will depre ciate the initial fixed asset investment straight-line to zero over the 6-year project life. It also estimates a salvage value of $506,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $262 per ton. The engineering department estimates you will need an initial net working capital investment of $547,000. You require a 13 percent return and face a marginal tax rate of 35 percent on this project. FIN3101 Page2 a. What is the estimated OCF and NPV for this project? b. Suppose you believe that the accounting department’s initial cost and alvage value projections are accurate only to within  ±14 percent; the marketing department’s price estimate is accurate only to within  ±9 percent; and the engineering department’s net working capital estimate is accurate only to within  ±4 percent. What is your worst-case and best-case scenario for this project? c. Suppose that you are confident about your own projections, but you are not sure about the Honda’s actual machine screw re quirements. What is the sensitivity of the project OCF to changes in the quantity supplied? What about the sensitivity of NPV to changes in quantity supplied? Given the sensitivity you calculated, is there some minimum level of the output below which you would not want to operate? Why? 6. The Cornchopper Company is considering the purchase of a new harvester. The break-even purchase price is the price at which the project’s NPV is zero. The new harvester is not expected to affect revenues, but pretax operating expenses will be reduced by $13,300 per year for 10 years. The old harvester is now 5 years old, with 10 years of its scheduled life remaining. It was originally purchased for $48,300 and has been depreciated by the straight-line method. The old harvester can be sold for $16,800 today. The new harvester will be depreciated by the straight-line method over its 10-year life. The corporate tax rate is 32 percent. The firm’s required rate of return is 13 percent. The initial investment, the proceeds from selling the old harvester, and any resulting tax effects occur immediately. All other cash flows occur at year-end. The market value of each harvester at the end of its economic life is zero. Determine the break-even purchase price in terms of present value of the harvester. FIN3101 Page3 How to cite Capital Budgeting, Essay examples Capital Budgeting Free Essays Capital Budgeting Process HSM 340 – Health Services Finances November 28, 2012 Organizations that decide to issue bonds generally go through a series of steps. Discuss the six steps. The six steps are: the borrower who is the health care evaluates the capacity of its debts, brings to date its capital plan, and tries to get its house in together, the borrower who is the health care chooses the main parties whom will take part in the bond issuance, the borrower who is the health care, is checked by a credit rating agency, the credit rating agency rates the bond, the borrower who is the health care, starts a loan agreement with the governmental authority, whoever issues the bonds and, the bonds are sold at the public offering price by the underwriters to bondholders, the trustees give the health care provider with the net proceeds. We will write a custom essay sample on Capital Budgeting or any similar topic only for you Order Now (Zelman, McCue, Glick, 2009) An alternative to traditional equity and debt financing is leasing. Leasing is undertaken primarily for what purposes? Leasing is undertaken for four reasons: they wish to avert the bureaucratic delays of capital budget requests, to get better maintenance service, to avert technological obsolescence, and so it can have convenience. (Zelman, McCue, Glick, 2009) Discuss the two major types of leases. The two major types of leases are operating and capital. With an operating lease, one would use this type if you wish to lease service equipment for periods shorter than the equipments economic life. These can be anywhere from a few days to a year. When one uses a capital lease, which can also be called a financial lease, they wish to lease it for all their economic life. This means the lessee must be committed to lease payments for the entire lease period. (Zelman, McCue, Glick, 2009) Discuss the terms short-term borrowing and long-term financing. When someone has to borrow, they should follow a rule of thumb and that is if you have short-term needs borrow short-term, if you have long-term needs borrow long-term. A debt with short-term financing must be paid be back quickly or debt that may not have to paid back for a year and refers to a wide range of financing. When one borrow for long-term financing it usually is a period longer than a year their debt must be paid off. Term loans and bonds are the two major types of long-term financing with bonds being the main source of long-term financing for health care entities that are tax-exempt. (Zelman, McCue, Glick, 2009) What are the primary sources of equity financing for not-for-profit healthcare organizations? Internally generated funds, philanthropy, and government grants are the primary sources of equity. Zelman, McCue, Glick, 2009) The capital budgeting process occurs in several stages, but generally includes what? In chapter 13 of The Financial Management of Hospitals and Healthcare Organizations , there are generally five steps that are done in the capital budgeting process and they are: identify and prioritize requests, project cash fl ows, perform financial analysis, identify non-financial benefits and, evaluate benefits and make decisions. (Capital Budgeting, 2007) Discuss and list the three discounted cash flow methods. As stated in our text, the most popular used firm valuations in healthcare is the DCF (Discounted Cash Flow) method. When using this approach there are three methods used and they are: for the next five years cash flows are estimated, after the cash flows are estimated they are then discounted to show the current value of the firm and, at the end of the fifth year, the value of the acquired firm will be estimated, or annual cash flows will no longer be estimated. (Cleverley, Song, Cleverley, 2011) Reference Cleverly PhD, William O. , Song PhD, Paula H. , Cleverly MHA, James O. Essentials of Heath Care Finance (7th Ed. ). Sudbury, Ma. Jones Bartlett Learning. Nowicki, Michael (15, July 2007). The Financial Management of Hospital Healthcare Organizations. Capital Management. Retrieved November 28, 2012 from http://www. dzcowan. com/Tech%20Attachments/HS%206200/Chapter_13_Nowicki. doc Zelman N. William. , McCue J. Michael. , Glick D. Noah. Financial Management of Healthcare Organizations: An Introduction to Fundamental Tools, Concepts, and Applications. (3rd Ed. ) San Francisco CA. Jossey-Bass. How to cite Capital Budgeting, Essay examples Capital Budgeting Free Essays Capital budgeting is used to plan for the acquisitions of other companies, for the development of new product lines of business, for the expansion of the existing production plants or for the replacement worn-out equipment, and in planning decisions on whether or not to enter a new arrest line, whether to buy or rent production facilities, and any other investment project resulting in costs and revenues that are spread over a number of years. Capital budgeting is the method used to assess a major investment or to see whether one option is better than another. There are several capital budgeting methods, each with advantages and disadvantages. We will write a custom essay sample on Capital Budgeting or any similar topic only for you Order Now In this article, we discuss the basic principle and the advantages and disadvantages of using the net present value technique and the internal rate of return technique. Net present value (NAP) method When using the net present value method of capital budgeting, one of most important factors is the estimation of net cash flows from an investment. The net cash flow is the difference between cash outflows and cash inflows over the life of the investment. First, cash flows should be calculated on an incremental basis, and include changes in operating cash flows and changes in investment cash flows. Second, cash flows must be measured on an after-tax basis. Third, non-cash expenses are also considered; for example, depreciation is an expense item but not a cash flow. Example 1 NP Ltd is considering an initial investment of $100,000 in order to open a new production line for a new product. The expected life of the production line is four years. Sales are estimated to be $100,000 during the first year and to increase by 10% per year until the fourth year. The variable costs of the producing the product are 50% of sales and the additional fixed costs are $1 5,000 per year. The simplified straight-line depreciation method is used to calculate depreciation. NP Ltd requires an after-tax return of 40% and also expects to recover $10,000 of its working capital at he end of the fourth year. The following gives the detailed information on the new product line: New product Initial investment $100,000 Salvage value $10,000 Expected life 4 years Annual operating costs Variable costs in the first year $50,000 Fixed costs $15,000 Sales during the first year The estimated cash flow from this investment are summarized as follows: Estimated cash flow Year 1 o,oho 50,000 1 5,000 25,000 10,oho 4,000 6,000 Net cash flow Add: 3 121,000 60,500 20,500 8,200 12,300 4 133,100 66,550 26,550 10,620 1 5,930 31,000 Sales Less: Variable costs Depreciation Profit before tax Less: Income tax Profit after tax Add: Depreciation 2 110,000 55,000 9,000 34,000 37,300 40,930 Recovery of working capital Net cash flow in year 4 60,930 We need to assign a discount rate to evaluate each of the competing alternatives for a firm’s capital to decide whether or not a firm should undertake an investment. The discount rate is estimated using the cost of capital of the investment to the firm. Net present value capital budgeting gives us the present value of the expected net cash flows from the investment, discounted at the firm’s cost of capital, minus the investment of capital needed today. For example, if NP Ltd expects a cost of capital of 12%, the net present value of the investment can be seen above, and the initial investment is $100,000, then the net present value of the new production line is: NAP = $120,054. 68 – $100,000 = $20,054. 68 This investment can add $20,054. 68 to the value of NP Ltd, so NP Ltd should undertake this investment. We can use the net present value method to compare investments. The project with the highest net present value is the better alternative. A disadvantage of the net present value technique is that the decision depends on the cost of capital: it is not easy to calculate this. The internal rate of return ORR) technique The internal rate of return technique is an alternative to the net present value technique. The internal rate of return on an investment is the discount rate at which the net present value of the investment is zero. The investment should be undertaken only if the internal rate of return on the investment exceeds the cost of capital to the firm. An advantage using the internal rate of return technique for capital budgeting is that he rate of return can be easily calculated and understood, especially by decision makers who may not have a financial background. Example 2 Using the information in example 1, we can calculate the internal rate of return to be 22. 05%. Since this exceeds the cost of capital, 12%, NP Ltd should undertake the investment. Example 3 Suppose we have two mutually exclusive investments: investment A and investment B, which are independent investments. The internal rate of return and cost of capital are calculated for each below. If the cost of capital is 12%, then both investment A ND B are acceptable because they both give a return greater than the cost of capital. In the other words, the cost of capital is the minimum acceptable rate of return. Internal rate of return of two mutually exclusive investments Investment A 20. 30% Cost of capital , per year Internal rate of return, per year Investment B 22. 10% Example 4 If we are forced to choose only one investment from example 3, we would choose investment B because this has a higher internal rate of return than investment A. However it is not enough to use only the internal rate of return technique to determine which is the best investment out of two or more mutually exclusive investments. We should also use the net present value method. The net present value and internal rate of return for the two mutually exclusive investments are shown below. Table 3: Internal rate of return and net present value of two mutually exclusive investments $137,872 Net present value at 12% discount rate $126,168 Investment B has a higher internal rate of return than investment A, so we have seen that we should undertake investment B. How to cite Capital Budgeting, Papers