Capital budgeting is an investment appraisal employed by firms in determining the overall viability of their various long-term investment opportunities such as acquiring of new machinery, installation of new plant among other investment opportunities ( Bierman & Smidt, 2012) . Thus, the main objective of capital budgeting investments is to increase the value of an organization. Various capital budgeting techniques are usually applied by a firm to evaluate its desirable investment opportunities. These techniques include net present value (NPV), discounted cash flow , risk-adjusted rate of return and internal rate of return (IRR).
Net Present Value (NPV)
Net present value is one of the main capital budgeting technique utilized by firms in evaluating the most desirable capital project amongst available alternatives. Net present value usually establishes which amongst the available projects being considered by a firm will generate the highest profit for its entire useful life ( Pasqual, Padilla, & Jadotte, 2013) . Net present value utilizes discounted cash-flows when evaluating a project to invest in, thus, making it the most correct capital budgeting technique as it considers both the risk and time variables of a project. Net present value is used to evaluate both independent as well as mutually exclusive projects. The net present value decision rule states that all projects whose computed net present value is positive should be accepted while those with negative net present value should be rejected. This means that, when a firm is faced with two mutually exclusive projects with positive NPV, the firm will be bound to accept the project with the highest NPV and in the event that both projects have a negative NPV, both of them should be rejected.
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Discounted Cash flow
Discounted cash-flow is a valuation technique used by firms to evaluate the suitability of potential investment opportunities. This valuation technique uses future free cash-flows by discounting them using an annual required rate of return to arrive at their present value estimates. The technique therefore, utilizes the present value estimates to evaluate the suitability of the investment projects at hand. Discounted cash-flow decision rule provides that the project should be accepted if the computed present value estimate is higher than the current cost of the investment otherwise it such project should be rejected ( Burns, & Walker, 2015) .
Risk-adjusted rate of return
Risk adjusted rate of return is an investment evaluation technique that evaluates a particular investment return by measuring the amount of risk likely to be involved in the production of the potential return generally expressed as a number or rating. The technique uses various risk measuring metrics including alpha, beta, R-squared, Sharpe ratio and the standard deviation ( Burns, & Walker, 2015) . A firm using risk-adjusted rate of return should, thus, rank their potential investment projects from lowest to highest in terms of their attractiveness.
Internal Rate of Return
Internal rate of return is a capital budgeting technique that firms usually utilizes to estimate the profitability of their prospective investment projects. This technique normally makes the NPV of all cash-flows from a particular project equal to zero. IRR decision rule provides that all projects whose IRR is higher than the firm’s required rate of return should be accepted otherwise the project should be rejected.
Part 1: Carroll Tree Ranch
Land purchase cost =$ 162,500
Current market value of the land = $ 410,000
NPV of the plant expansion (R) = $ 65,000
Cost of the plant expansion = $ 865,000
Discounted cashflow of plant expansion = $ 930,000
Number of land investment in years (n) = 15 years
Assuming that the expected rate of return of this investment to be (r) 10%
NPV = [R *NaN/r]-Initial cost of land
NPV = [$ 65,000* -0.10000000000000009 -15 /0.10] - $ 865,000
[ $ 65,000*7.61]- $ 865,000
NPV = $ 494,650- $ 865,000
NPV = -$ 370,350
Since the resulting NPV of $ 370,350 is negative, Carroll Tree Ranch should not undertake the plant expansion project since the project would result into a loss. However, the initial cost of the land of $ 162,500 should not be included in the analysis of this project since it has already been incurred.
Part 2: Housing Markets
a)
Assumable mortgage rate= 8%
Present value of the home = $ 60,000
Interest rate (r) = 7.5 %
Remaining mortgage time = 30 years
Thus, the Future value will be given by:
FV = PV+ P(1+r) -30
FV = $ 60,000 +$ 60,000(1+0.075)- 30
FV = $ 60,000 + ($ 60,000*0.1142)
FV = $ 60,000+$6,852
FV = $ 68,852
b)
Interest rate = 7.5%
Tax of the third home = PV(1+r) -30
Tax = $1,000(1+0.075) -30
Tax = $ 1,000*0.1142 = $ 114
Therefore, the selling price of the third home will be given by:
Selling price of your home-tax
Selling price = $ 68,852 -$ 114 = $68,738
References
Pasqual, J., Padilla, E., & Jadotte, E. (2013). Equivalence of different profitability criteria with the net present value. International Journal of Production Economics , 142 (1), 205-210.
Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects . Routledge.
Burns, R., & Walker, J. (2015). Capital budgeting surveys: the future is now.
