Capital Budgeting Techniques

Explain the net present value (NPV) method for determining a capital budgeting project's desirability. What is the acceptance benchmark when using NPV? 

The net present value is a capital budgeting technique that that analyzes the viability and profitability of an investment to be undertaken. This method is used by companies or potential investors to determine if it would be a wise decision to invest their capital into a certain project. During the lifetime of a project, the owners incurs a significant cash flow which is in form of the initial capital pumped into the project to keep it up and running. The viability of the investment is measured by the ability of the project to generate future cash inflows that will compensate the invested amount and still have a positive cash flow. As at the start of the project, the expected future cash flows are estimated. These future cash flows are discounted with a specified interest rate to find the equivalent total present value. Since the initial investment is made presently, the net present value is the difference between the present value of cash outflows and the initial capital.

The acceptance benchmark of the project when using the NPV is if it is equal to or greater than zero. A positive NPV implies that that the project has the potential of compensating the initial amount invested and still generate a positive cash flow. The project is rejected when it has a negative NPV of less than Zero (Weaver & Weston, 2001). This would imply that the expense incurred to set up the project would not be recovered and it would not result to additional cash inflows.

Explain the payback period statistic. What is the acceptance benchmark when using the payback period statistic? 

An investment is always expected to generate a given amount of cash inflow periodically. The investors aim is to cover up the initial cost incurred to set up the project and generate additional revenues. The payback period is the estimated time that the project at hand will take to generate cash inflows that will recover the initial capital. The project can generate the same amount of cash inflows periodically or differing amount. The owners usually estimate a given time that they expect to cover the initial capital. The acceptance benchmark is when the maximum allowable payback period to recover the initial capital invested is less or equal to the actual calculated payback period (Bierman & Smidt 2012). It the tie calculated is more than what had been estimated and allowed, then the project is rejected. This is because a longer period would beat its economic sense. 

Describe the internal rate of return (IRR) as a method for deciding the desirability of a capital budgeting project. What is the acceptance benchmark when using IRR? 

The internal rate of return is a capital budgeting technique is which determines the desirability of a project by measuring its profitability. The IRR is a discounting rate which equates the NPV of an investment at Zero (Bierman & Smidt 2012). The IRR works effectively when the investment generates continuous cash flows and the rate is highly determined through a trial and error process. When acquiring funds for a project, the investor could borrow funds and be charged a cost of capital. The acceptance benchmark when using IRR as an investment technique is when the IRR is greater than or equal to the cost of capital. When comparing different projects, the one with the highest IRR is the most desirable. The project is rejected if it has an IRR which is less than the cost of capital.

Describe the modified internal rate of return (MIRR) as a method for deciding the desirability of a capital budgeting project. What are MIRR's strengths and weaknesses? 

The modified internal rate of return is an investment technique which is modified to account for the difference between the investment return and the re-investment risk. The MIRR is a form of calculating the IRR by adjusting the cash flows to take into account the cost of capital before calculation. The positive cash flow is moved towards the terminal date of the project. The modification is through taking the negative cash flows and moving them to the zero period of the initial capital. It is after these adjustments that the IRR is then calculated. The benchmark for acceptance of IRR is same as that of IRR. It is accepted when the MIRR is higher than the cost of capital. A strength that MIRR exhibits is that it accurately reflects the cost and the profitability of a given project. Moreover, it does not assume that cash flows are re-invested back into a project using the same rate of return. It hence eliminates the limitations of the IRR. One of the weaknesses of the MIRR is that it calls for two additional decisions for the cost of capital and the rate of financing which are mainly estimates (Ross et al., 2002).

Computations 

Based on the cash flows shown in the chart below, compute the NPV for Project Huron. Suppose that the appropriate cost of capital is 12 percent. Advise the organization about whether it should accept or reject the project. 

Year	Cash flow	Pvif (12%)	Present value
0	-12000	1	-12000
1	2360	0.893	2107.48
2	4390	0.797	3498.83
3	1520	0.712	1082.24
4	3300	0.636	2098.80
NPV	-$3212.65

NPV= total present value – initial capital 

Present value = cash flow * present value interest factor (pvif) at 12% 

NPV= 2360*0.892 + 4390*0.797 + 1520*0.711 + 3300*0.635 = 

2105 + 3499 + 1081 + 2096 = 8781 

8781 – 12000 = -3212.65 

NPV is =$3212.65

Since the NPV of the project is negative, it should be rejected

Based on the cash flows shown in the chart below, compute the IRR and MIRR for Project Erie. Suppose that the appropriate cost of capital is 12 percent. Advise the organization about whether it should accept or reject the project. 

Project Erie
Time	0	1	2	3	4	5
Cash Flow	$12,000	$2,360	$4,390	$1,520	$980	$1,250

IRR = cash outflow/ cash inflow

Initial capital =12000

12000/ 2100 = 5.714

Using the annuity table, the estimated IRR would be = 7% 

MIRR= (present value of all positive cash flows) ^ 2 / (present value of all negative cash flows) ^ 2 

(8020) ^ 2 / (12000) ^ 2 = 0.446

MIRR = approximately 4% 

References

Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects . Routledge.

Gitman, L. J., & Forrester Jr, J. R. (1977). A survey of capital budgeting techniques used by major US firms. Financial Management , 66-71.

Ross, S. A., Westerfield, R. W., & Jaffe, J. F. (2002). Corporate Finance.

    Sherman, E. H. (2011). Finance and accounting for nonfinancial managers (3rd ed.). New York, NY: American Management Association.

Weaver, S. C., & Weston, J. F. (2001). Finance and accounting for nonfinancial managers. New York, NY: McGraw-Hill.