FMGT201: Module 3 Assignment - Capital Budgeting Techniques

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Financial Management
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Table of Contents
Introduction......................................................................................................................................3
Problem 1.........................................................................................................................................4
Problem 2.......................................................................................................................................10
Problem 3.......................................................................................................................................12
Problem 4.......................................................................................................................................14
Conclusion.....................................................................................................................................18
References......................................................................................................................................19
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Introduction
The following assignment gives knowledge about the project decisions and the ways in which
such projects can be evaluated to select the best alternative from the available projects. Also, it
explains the different capital budgeting criteria and its pros & cons. Also, analysis of the
company's financial cash flows and Cost of capital for accepting the new project is also
described below, comparing the same with the WACC of the company.
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Problem 1
Project A
Calculation of NPV
Year Cash Flow PVF @10% PV of net cash flow
1 30000 0.909 27270
2 40000 0.826 33040
3 50000 0.751 37550
4 60000 0.683 40980
Present value of Cash Inflow 138840
Present Value of Cash Outflow(Initial Investment) 100000
NPV 38840
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Calculation of IRR
Year Cash Flow PVF @10% PV of net cash flow
0 -100000 1 -100000
1 30000 0.909 27270
2 40000 0.826 33040
3 50000 0.751 37550
4 60000 0.683 40980
Internal Rate Of Return 14%
Project B
Calculation of NPV
Year Cash Flow PVf @8% PV of net cash flow
1 6000 0.926 5556
2 6000 0.857 5142
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3 6000 0.794 4764
4 6000 0.735 4410
Present value of Cash Inflow 19872
Present Value of Cash Outflow(Initial Investment) 20000
NPV -128
Calculation of IRR
Year Cash Flow PVF @8% PV of net cash flow
0 -20000 1 -20000
1 6000 0.926 5556
2 6000 0.857 5142
3 6000 0.794 4764
4 6000 0.735 4410
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Internal Rate Of Return -0.27%
Project C
Calculation of NPV
Year Cash Flow PVf @10% PV of net cash flow
1 85000 0.909 77265
2 80000 0.826 66080
3 75000 0.751 56325
4 70000 0.683 47810
Present value of Cash Inflow 247480
Present Value of Cash Outflow(Initial Investment) 200000
NPV 47480
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Calculation of IRR
Year Cash Flow PVF @10% PV of net cash flow
0 -200000 1 -200000
1 85000 0.909 77265
2 80000 0.826 66080
3 75000 0.751 56325
4 70000 0.683 47810
Internal Rate Of Return 9.96%
(A)
If the projects are not mutually exclusive then, in that case, the company should invest in the
projects which is more beneficial keeping in mind that it can invest in more than one project
also as the projects are not mutually exclusive. Assuming that the fund available in the firm
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is $500000, then, in that case, the company should first invest the amount in project C as the
project has the highest NPV. If money remains after investment in project C then the
remaining money can be invested in Project A as the second-best alternative as per above
analysis is Project A. However Project B should not be taken into consideration as the NPV
of the same is negative. Thus below is the preference chart for the not mutually exclusive
projects:
Serial Number Projects Ranking
1 Project A Rank 2
2 Project B Rank 3
3 Project C Rank 1
(B)
If the projects are mutually exclusive then the firm should choose the best alternative
available of the given alternatives as in case of mutually exclusive projects only one
alternative can be chosen at a time. Thus as per the above analysis, the project whose NPV is
the highest and IRR positive should be selected. Project B should not be selected as it has a
negative NPV thus the selection is to be made between Project A & Project C. NPV of both
the projects is positive, however, the NPV of Project C is higher as compared to Project A
and also IRR of the same is positive. Thus as per the above analysis in case of mutually
exclusive projects, Project C is the most preferred project of the three projects given as it has
the highest NPV and IRR is also positive.
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Problem 2
Following are some of the capital budgeting criteria and methods introduced in class:
 Net Present Value- Net Present Value is the difference between the present value of cash
inflow and the present value of cash outflow. With the help of the NPV method project
can be analyzed and decision on the same can be taken that whether such a project should
be selected or investment should be made or not. NPV uses the time value of money to
analyze the project. For the project to be accepted by the firm the NPV of such project
should be positive (Benamraoui, ET, Al., 2017).
Following are the advantages of the NPV Method:
 NPV takes into account the time value of money and discounts the future amounts
into present value
 NPV specifies whether the project would create future value for the company
Following are the Disadvantages of NPV Method:
(A) In NPV method firm has to make certain estimations which can turn out to be
incorrect like Cost of capital, future cash flows etc.
 Payback Period- Payback period is the period in which the initial investment cost of the
project would be recovered by the company by the cash inflows of the company. It is
calculated on a yearly basis like if a project has an investment of $300000 then it could
be recovered in how many years, that number of years is known as payback period
(Awomewe, 2008).
Advantages of Payback period are:
(A) Payback period is the simplest method to calculate and compare as it is easy to
compare the viability of the project from the payback period.
Disadvantages of Payback period are:
(A) Payback period does not consider the time value of money which is a major
disadvantage in calculating the viability of the project.
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 Internal Rate of Return- Internal Rate of return is the rate at which the present cash
inflow of the project is equal to the present value of cash outflow. If IRR is greater than
the required return of the company then the project is desirable (Magni, 2010).
Advantages of IRR are:
(A) IRR allows the firm to compare its required rate of return with the actual rate of
return and is most suitable for venture capital & private equity instruments.
Disadvantages of IRR are:
(A) IRR does not consider various other factors like the future flow of cash, size of the
project and duration of the project.
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Problem 3
In the given problem decision is to be made whether vinyl sliding is to be installed in the house
or paint is to be done. Thus to take such decision total present value of the cost for the two
options should be analyzed and the option with lower cost should be selected.
Scenario 1- Install Vinyl Sliding
To install vinyl sliding an initial cost is to be incurred of $ 13000 today and which will last for 25
years.
Cost At the Start of the year= $13000
Scenario 2- Get the paint job done
If paint job is done then in that case the paint job would cost $3500 today and it would increase
by 5% every year. Also paint job would last only for 5 years and it is assumed that it is redone
after every 5 years. Additional cost of $2500 would also be incurred for replacing the boards
which will last for 25 years. The cost of capital is 10%. Following will be the present value of
cost incurred in the coming 25 years if paint is done:
Particulars Amount PVF Present Value
Year 0 $ 3,500.00 1 $ 3,500.00
Year 0 $ 2,500.00 1 $ 2,500.00
Year 5 $ 4,466.99 0.621 $ 2,774.00
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