Capital Budgeting
Capital Budgeting
Capital Budgeting
Solution,
NPV =Present Value of Cash Inflows(PVCI )−Present Value of CashOutflows (PV C O)where ,
Present Value of Cash Inflow=Equal Annual Cash inflow × Present Value Interest factor of Annuity (PVIFA)
Present Value of CashOut flows=Cash outflow × Present Value Interest facto r
Here, PVCO = Initial Investment
Decision Criteria : Select the Projects having positive NPV. If the Projects are mutually exclusive, Select
the Project having highest positive NPV.
Decision : Project A and Project C can be accepted. If the Projects are mutually exclusive, Only Project A
is selected. However, Project B cannot be accepted.
QUESTION 4: PAYBACK AND NPV
a) Calculation of Payback Period
Formula/concept used:
Payback Period: It is the time period within which the initial investment in the project is returned back to
the investors. In order to calculate the payback period, the cumulative cash inflow is compared with the
initial investment. The period in which the cumulative cash inflow becomes at least equal to the initial
investment is the payback period.
Decision Criteria: Select the project having the least payback period.
Formula/concept used:
PV = Present Value = Annual cash Flow × Present Value Interest Factor ( PVIF )
Decision Criteria : Select the Projects having positive NPV. If the Projects are mutually exclusive, Select
the Project having highest positive NPV.
As per part a, Project C has the least payback period and as per part b, Project C has the highest NPV.
Project B has Negative NPV. So, It can’t be selected. Thus, I recommend the Project C.
c) Calculation of the sum of the present values and the NPV for
both the 12% and 14% scenarios.
d) Calculation of the internal rate of return using the trial and error method
The NPV @ 12% is positive whereas the NPV @ 14% is negative, Thus, the Internal Rate Of
Return lies Between 12% and 14%.
Calculating NPV @ 13%
Solution,
Formula/Concept used:
IRR is the discounting rate at which NPV of the project is equal to zero.
At 10% discounting rate, NPV of Project A is zero. Therefore, The Internal rate of Return is 10%.
Considering the 212.5 as a round off error, We consider the IRR for the Project B to be 24%.
Decision Criteria:
Select the project having highest IRR provided that the IRR of the selected project is more the cost of
capital.
Decision:
The IRR of Project A is less than the cost of capital. The cost of capital is 12%. However the IRR of Project
B is more than the cost of capital. So, Select the project B.
Here is an explanation of the advantages and disadvantages between the following capital budgeting
methods: payback period, net present value (NPV) and internal rate of return (IRR)