Techniques of Capital Budgeting: Analysis and Limitations

Running Head: Capital Budgeting Analysis
TECHNIQUES OF CAPITAL BUDGETING

Capital Budgeting Analysis 10
Answer 1
Project A Project B
Cost $ 500,000.00 $ 300,000.00
Profit/ Loss - Year 1 $ 145,000.00 $ 90,000.00
Profit/ Loss - Year 2 -$ 5,000.00 -$ 10,000.00
Profit/ Loss - Year 3 $ 6,000.00 $ 20,000.00
Estimated residual value $ 35,000.00 $ 30,000.00
Adding Depreciation value back to
cash-flow
Depreciation amount $ 465,000.00 $ 270,000.00
( Cost - Estimated
residual value )
Annual Depreciation $ 155,000.00 $ 90,000.00
( Depreciation
amount / No of
years )
Cash-flow including depreciation
( Annual Profit or
Loss + Annual
Depreciation )
Year 1 $ 300,000.00 $ 180,000.00
Year 2 $ 150,000.00 $ 80,000.00
Year 3 $ 161,000.00 $ 110,000.00
Part a)
Net Present Value
Total Cash
flows A
Cost of Capital 10% scrape
Year 0 1 2 3 3
Cash flow -$ 500,000.00 $ 300,000.00 $ 150,000.00 $ 161,000.00 $ 35,000.00
PV ( FV/(1+r)^n
) -$ 500,000.00 $ 272,727.27 $ 123,966.94 $ 120,961.68 $ 26,296.02
NPV for
Project A $ 43,951.92
( NPV = Sum of
PV from Y0 to
Y3 + Scrape )
Total Cash
flows B
Cost of Capital 10% scrape
Year 0 1 2 3 3
Cash flow -$ 300,000.00 $ 180,000.00 $ 80,000.00 $ 110,000.00 $ 30,000.00
PV ( FV/(1+r)^n -$ 300,000.00 $ 163,636.36 $ 66,115.70 $ 82,644.63 $ 22,539.44

Capital Budgeting Analysis 10
)
NPV for
Project B $ 34,936.14
( NPV = Sum of
PV from Y0 to
Y3 + Scrape )
Part b)
Internal rate of return
Total Cash-flows A
Cost of Capital 10%
Year 0 1 2 3
Cash-flow -$ 500,000.00 $ 300,000.00 $ 150,000.00 $ 196,000.00
IRR for Project A 15.42%
(15.42% less cost of capital 10%
= 5.42% profit)
Total Cash-flows B
Cost of Capital 10%
Year 0 1 2 3
Cash-flow -$ 300,000.00 $ 180,000.00 $ 80,000.00 $ 140,000.00
IRR for Project B 16.93%
(16.93% less cost of capital 10%
= 6.93% profit)
Part c)
Payback Period
Total Cash-
flows A
Cost of Capital 10%
Year 0 1 2 3
Cash-flow -$ 500,000.00 $ 300,000.00 $ 150,000.00 $ 196,000.00
Cash Y1+Y2 $ 450,000.00
Shortfall -$ 50,000.00
( The sum of
Cash-flow +
(Cash Y1+Y2) )
Cash Y3 $ 196,000.00
Cash Monthly
Y3 $ 16,333.33 Cash Daily Y3 $ 536.99
Months
required 3.06 Days required 93.11
Payback
Period A
2 years and 3.06
months or 2

Capital Budgeting Analysis 10
years and 93
days
Total Cash-
flows B
Cost of Capital 10%
Year 0 1 2 3
Cash-flow -$ 300,000.00 $ 180,000.00 $ 80,000.00 $ 140,000.00
Cash Y1+Y2 $ 260,000.00
Shortfall -$ 40,000.00
Cash Y3 $ 140,000.00
Cash Monthly
Y3 $ 11,666.67 Cash Daily Y3 $ 383.56
Month required 3.43 Days required 104.29
Payback
Period B
2 years and 3.43
months or 2
years and 104
days
Part d)
Profitability Index (PI) ( PI = NPV/investment outlay )
Project A $0.09
Project B $0.12
Part e)
Optimal rate of return
Total Available funds $ 500,000.00
Total funds required to invest in both the
projects $ 800,000.00
Shortage of funds $ 300,000.00
In case of shortage of funds, capital rationing can be applied in the following manner: