Financial Analysis Report: Evaluating Capital Budgeting Techniques

This financial analysis report addresses key capital budgeting techniques. It begins by explaining the Net Present Value (NPV) method, its strengths, and weaknesses, and its use in evaluating investment projects. The report then details the payback period statistic, its acceptance benchmark, and the improvements offered by the discounted payback period. Furthermore, the report explores the Internal Rate of Return (IRR) method, comparing it to NPV and highlighting similarities and differences. The Modified Internal Rate of Return (MIRR) is also analyzed, emphasizing its advantages over IRR and NPV. The report includes computations of NPV for a project and a payback period analysis, demonstrating the application of these methods in practical scenarios. References to relevant academic sources support the analysis.

Running head: FINANCIAL ANALYSIS
Financial Analysis Report
Name of the Student
Name of the University
Author Note

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FINANCIAL ANALYSIS
Table of Contents
Answer to question 1.......................................................................................................................2
Answer to question 2.......................................................................................................................2
Answer to question 3.......................................................................................................................2
Answer to question 4.......................................................................................................................2
Answer to question 5.......................................................................................................................2
Answer to question 6.......................................................................................................................2

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FINANCIAL ANALYSIS
Answer to question 1
The net present value (NPV) method for calculating the capital budget of a particular
project is the ideal procedure. The business owners should use this process while evaluating
whether to invest or not in a particular business or not. It gives the most accurate form of
mathematical point of view and time value for money point of view solution (Roise et al., 2016).
The NVP method gives more correct than the profitability index and internal rate of return
process of capital budget evaluation.
The net present value method is generally used when the capital investment project are
large in terms of scope and money. In Net Present Value analysis, the discounted cash flows are
used. It considers both risk and time variables. The cash flows are forecasted are delivered by a
project discounting them back to the present value with the use of time span of the project and
the weighted average cost of capital of the firm.
The benchmark to determine the acceptance of the project is when the result is positive
then the firm should invest in the project and if it is negative, the firm should rethink.
The main advantage of NPV is that it considers the idea that the future value is less than
the present value (Gabriel Filho et al., 2016). Therefore, the cash flows are discounted by the
capital cost of another period. The NVP also helps to understand whether an investment will be
beneficial for a company or not .It also takes the amount by which the business decision will
increase the firm’s value. The final advantage of NPV is that it takes into account both the cost
and the risk in the project.

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FINANCIAL ANALYSIS
The biggest limitation of using the Net Present Value method requires a lot of
assumptions and guesswork about the firms cost of capital.id the cost of capital taken in hand is
too low then the result of investment may not me optimal whereas if the assumed cost of capital
is too high the result in investment is good (Schmidt, 2015). Moreover, the NPV is not a useful
method to compare the two projects with different size as the unit id the NPV result is in terms of
money and size of the input cannot be determined.
Answer to question 2
The payback period statistic helps in decision-making process of the firms and the
accuracy of the rate of return on the investment. The payback period refers to the amount of time
required to recover the investment cost (Roise et al., 2016). The payback period helps go
determine the decision whether or not a firm should undertake a project or not (Ross et al.,
2014). The payback period of capital budgeting ignores the time value for money unlike other
methods like internal rate of return discounted cash flow and net present value. In the process of
payback period the number years covered to recover the investment of fund is considered.
The benchmark to understand the desirability of a business is the length of the payback period.
The longer the payback period the lesser desirable is the project (Schmidt, 2015).
The problem, which is faced in the method of pay back period, is that, it does not take into
account the time value for money. The discounted payback method sums up the present values of
the cash flows until zero is reached.

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FINANCIAL ANALYSIS
Answer to question 3
The internal rate of return is similar to decision-making process of that of NPV. While
calculating the NPV, the present value of the cash flow is summed up at particular interest rate
(Gabriel Filho et al., 2016). The IRR refers to that interest rate. The NPV equals the main cause
to zero. It determines the profitability and potentiality of the investments.
The benchmark of IRR is that if the Cost of Capital is more or equal to the project, the project
with high IRR is approved. If the IRR is lower than the cost of capital, the project with lower
IRR is approved (Schmidt, 2015).
The similarity between NPV and IRR is that both of them consider the time value for
money. For independent investment proposals, where there is no competition with each other, the
result of both NPV and IRR is same (Gabriel Filho et al., 2016). Similarly, in investment
proposals that involve cash outflows in the initial period followed by series of inflow, the result
under both methods is the same.
The dissimilarities between the two are shown in the following table:
NET PRESENT VALUE METHOD INTERNAL RATE OF RETURN METHOD
 The determination of the discount rate
is by discounting of the future cash
flows of a project.
 It gives importance to the market rate
of interest.
 Cash inflows are reinvested at the cost
of capital or cut off rate.
 The discount rate is not determined
beforehand under this process. It is
calculated on trial and error basis.
 It does not consider any market rate of
interest but invests at maximum rate of
interest (Gabriel Filho et al., 2016).
 Cash inflows are reinvested at internal

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FINANCIAL ANALYSIS
rate of return.
Answer to question 4
The modified internal rate of return is a process to rank the investment projects of
unequal size. It assumes that positive cash flows are reinvested at the cost of capital of the firm
and the initial outflows of cash are financed at the cost of the firm. The MIRR is the most
accurate form of calculating the cost and profitability of any investment project (Gabriel Filho et
al., 2016).
The advantage of the MIRR is that it is a better and improved method for evaluating a
project. It takes care of all the shortcomings of the IRR and NPV method of calculation.
Moreover, it is easily understandable as it takes into account the possible reinvestment rate.
The disadvantage of MIRR is that it asks for both financing rate and cost of capital. It involves
two additional decisions that may lead to confusion. The managers may hesitate in involving two
different estimates (Gabriel Filho et al., 2016).
MIRR does not assume that all cash flows will be re-invested in projects with the same
rate of return that IRR does. This is the point of difference between the two. The MIRR would
help in comparison to other projects in a better way.
Answer to question 5
Computation of NPV of project Y:

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FINANCIAL ANALYSIS
NPV = C x {(1 - (1 + R)-T) / R} − Initial Investment, where C is the expected cash flow per
period, R is the required rate of return, and T is the number of periods over which the project is
expected to generate the income.
year PV of 10% (1 - (1 + R)-
T) / R)
Cash flow (in $) PV of Cash flow
0 1 -6000 -6000
1 .9090 3350 3045.15
2 0.82640 4180 3454.352
3 0.7513 1520 1141.976
4 0.6830 300 204.9
NPV= 9692.756
The NPV calculated in project Y is positive, therefore, the firm could undertake the
project as the market value of the firm would enhance by the amount of the NPV.
If the firm encounters a decrease in the cost of capital, it would invest more in long-term
projects. This would allow the companies enhance its debt to equity.

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FINANCIAL ANALYSIS
Answer to question 6
Payback Period = years full recovery + unrecovered cost at beginning of last year
cash flow in following year
computation of payback period:
year Cash flow(in $) Cumulative cash flow( in $)
0 -1450
1 250 -1200
2 380 -820
3 620 -200
4 1000 800
5 100 900
The payback period lies between year 3 and year 4, which can be taken as 3.2 years.
There is a $200 of investment yet to be made and there is a projection of $1000 at the end of year
4.It can be hereby assumed that there is similar monthly amount of flow of cash in year. That
implies that the business has a payback of 3.5 years. Therefore, the project is desirable.
If the discounted payback period is calculated it would always be greater than the non discounted
payback period if the cash flow is positive.

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References
Gabriel Filho, L. A., Cremasco, C. P., Putti, F. F., Goes, B. C., & Magalhaes, M. M. (2016).
Geometric Analysis of Net Present Value and Internal Rate of Return. Journal of Applied
Mathematics & Informatics, 34, 75-84.
Roise, J. P., Harnish, K., Mohan, M., Scolforo, H., Chung, J., Kanieski, B., ... & Shen, T. (2016).
Valuation and production possibilities on a working forest using multi-objective
programming, Woodstock, timber NPV, and carbon storage and
sequestration. Scandinavian Journal of Forest Research, 31(7), 674-680.
Ross, S. A., Westerfield, R., & Jaffe, J. F. (1990). Corporate finance (Vol. 2). Homewood:
Irwin.
Schmidt, R. (2015). How to Use the Modified Internal Rate of Return (MIRR), PropertyMetrics.