ASSIGNMENT
“Capital Budgeting”
Business Finance
Assignment No. 01
Submitted To: Prof. Ayub Arshad
Submitted By: Alina Amir
Registration No. M1F17BBAM0001
Program: BBA
Semester: 6th
University of Central Punjab
PART A
Calculate each project payback period
Project M: initial investment/ average cash flow
= 28500/10000
= 2.85 years
Project N
Year cash inflow (CF1) Cumulative cash
1 10000 11000
2 10000 10000
3 10000 9,000
4 10000 8,000
= 2+ [ ($27000-$21000)/$9
= 2+6000/9000
=2.67
(B)
Calculate the present value (NPV)for each project:
Project M= present value of cash flow – initial value
10000(PVIF14%, 4years)-28500
= ($10000*2.914)-$28500
=$640
Project (N)
Year CFt PVIF(14%) PV=CFT*PVIF
1 1100 0.877 $9,647
2 10000 0.769 $7690
3 9000 0.675 $6075
4 8000 0.592 $4736
PV (cash inflows) $28,148
Initial investment 27000
NPV $1,148
(C)
Calculate the profitability index:
Project M = present value of cash flow/ initial value
=$29,137/$28,500
= 1.02
Project N
Years cash flow PVIF14% PV
0 27000 1
1 11000 0.8772 9649.2
2 10000 0.7695 7695
3 9000 0.6750 6075
4 8000 0.5921 4736.8
28156
= 28156/27000
=1.04
Project N will be accepted
(D)
Calculate the internal rate of return (IRR) for each project:
Project N
Discount rate(%) NPV(M) NPV(N)
$11,50
0 0 $11000
5 6,960 6,903
10 3,199 3,490
15 50 618
16 -518 99
Project M:
IRR=15.086
Project N:
IRR: 16.1935%
E. Summarize the preference dictated by each measure you calculated, and indicate
which project you would recommend. Explain why?
I will select NPV because IRR value is greater and payable period are less. NPV is more and
its profitability index is also higher. After all the analysis, project N would be the best choice
because of the following reason. First, it has a higher NPV. Second, the payback period is
shorter thans project M’s period back. Third project N has higher IRR. The last reason is that
NPV has much ‘higher power’ than IRR since it ranks Capital Budgeting Ranks.
QUESTION NO. 2: What are the pros and cons of different capital budgeting
techniques?
Capital budgeting: Capital budgeting is the process a business undertakes to evaluate
potential major projects or investments. Construction of a new plant or a big investment in an
outside venture are examples of projects that would require capital budgeting before they are
approved or rejected. When a company is looking at, for example, acquisitions of other
companies, development of new lines of business or major purchases of plants or equipment,
capital budgeting is the method used to determine whether one option is better than another.
There are several capital budgeting methods, each with its pros and cons.
Pros and cons of Capital Budgeting
1. Capital Budgeting by Payback Period
The most-used method of capital budgeting is determining the payback period. The company
establishes an acceptable amount of time in which a successful investment can repay the cost
of capital to make it. Investment alternatives with too long a payback period are rejected.
Investment alternatives inside the payback period are evaluated on the basis of the fastest
payback.
Payback method disadvantages include that it does not account for the time value of money.
2. Net Present Value Capital Budgeting
In net present value capital budgeting, each of the competing alternatives for a firm’s capital
is assigned a discount rate to help determine the value today of expected future returns. Stated
another way, by determining the weighted average cost of capital over time, also called the
discount rate, a company can estimate the value today of the expected cash flow from an
investment of capital today. By comparing this net present value of two or more possible uses
of capital, the opportunity with the highest net present value is the better alternative.
A disadvantage of the net present value method is the method's dependence on correctly
determining the discount rate. That calculation is subject to many variables that must be
estimated.
3. The Internal Rate of Return Method
An advantage of capital budgeting with the internal rate of return method is that the initial
calculations are easier to perform and understand for company executives who may not have
a financial background. Excel has an IRR calculation function.
The disadvantage of the IRR method is that it can yield abnormally high rates of return by
overestimating the value of reinvesting cash flow over time.
4. A Modification of the Internal Rate of Return Method
The modified rate of return method overcomes the tendency to overestimate returns by using
the company’s current cost of capital as the rate of return on reinvested cash flow.
As with all methods of capital budgeting, the modified rate of return method is only as good
as the variables used to calculate it. However, by using the firm’s cost of capital as one
variable, it has a figure that is grounded in a verifiable current reality and is the same for all
alternatives being evaluated.
5. The Accounting Rate of Return
Many financial professionals in a firm, as opposed to top management, prefer the accounting
rate of return because it is most grounded in actual numbers. Determining an investment’s
accounting rate of return is a matter of dividing the expected average profit after taxes from
the investment by the average investment. However, as with the payback period method, it
does not account for the time value of money.
