Subject:Various Techniques of Capital Budgeting
The Management
Subject:Various techniques of capital budgeting
Capital budgeting is the process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.There are many techniques which can be use make decision more easy and reliable.
For all of these techniques company need the incremental cash flows which will be generate from the investment or the project. Then these cash flows are discounted according to the company cost of capital rate which is also known as weighted average cost of capital (WACC).
Following are the techniques which are normally used in capital budgeting:-
- Net Present Value
- Internal Rate of Return
Net Present Value (NPV):-
NPV can be described as the “difference amount” between the sums of discounted: cash inflows and cash outflows. It compares the present value of money today to the present value of money in the future, taking inflation and returns into account
If the net present value of any project or investment is positive then only that project is accepted otherwise it should be rejected, as the NPV is negative. If the NPV is zero than it is assumed that it is positive. It is the best technique available in these days and is most reliable one as it gives more accurate results. If the discount rate do change then the result will also be change, as in the case c the present value of both the discount rate differ like NPV at 10% is $20,979 and NPV at 11% $40,251.
Internal Rate of Return:-
Internal rate of return also known as IRR is also another technique to make decision easy and reliable. The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.
As in this case the IRR for the two corporation are 13.05% and 16.94% respectively, so according to IRR only the corporation B should be selected , but the decision cannot be taken by considering the IRR only there are some other thing which also should be taken in to account before the decision is taken.
IRR is the second technique which is more reliable and accurate than others after the NPV, so in much business this technique gains attention for the decision making purposes.
Conclusion:-
According to the analysis the corporation B should be selected, as it NPV is greater. All the other factors must also be put in consideration for the decision such as IRR, Payback periods etc to compare the better result from both the corporation, but final decision should be based on NPV because this give the more accurate and reliable results. The NPV for the project A is also positive but the projects are mutually exclusive which means the company can only consider one project at a time , due to some lack of resource so It must select the corporation B on the basis on NPV of corporation B which is $40,252.
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William Wordsworth
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Two variables selected are changes in revenues and tax rate. It is assumed that revenues will increase only by 5% for both corporations, instead of 10% for A and 8% for B. And the tax rate is expected to rise to 35% instead of 25%. These changes will mitigate the expected future cash flow for both corporations, which will result in change in values of NPV as compared to those NPVs calculated earlier using original data. The change in NPV will change the decision of the company regarding investment in one of two corporations. The NPV will be negative for both corporations as calculated in excel sheet, therefore company will not invest in any of the corporations due to negative NPV of both corporations.