Paper Topic:

Capital Budgeting

Capital Budgeting

Part 1 : Determine if the new machine should be purchased . Use NPV , IRR and Payback in your analysis where appropriate . Refer to the articles below and the background materials in your analysis

Payback Period

Using Payback Period to determine if the new machine should be purchase The Payback Period Calculation is as follows The project cost is 1 , 000 ,000 . The expected return of the project amount is 100 ,000 . The payback period will be 10 years

Net Present Value (NPV

Using the discounted rate of 10 and

projecting that the life of the project will be 10 years , with its initial project cost of 1 ,000 ,000 .00 then we can say that the NPV is 187 ,828 .70 . With a discount rate of 10 .00 and a span of 10 years , your projected cash flows are worth 1 ,187 ,828 .70 today , which is greater than the initial 1 ,000 ,000 .00 paid . The resulting positive NPV of the above project is 187 ,828 .70 which indicates that pursuing the above project may be optimal

Remember that even though a project offers a plosive NPV , the projected cash flows are still estimations . The accuracy of these projected figures depends on the skill and experience of the analyst , and likelihood of these cash flows materializing depends on the financial risk associated with the type of project being pursued

Part 2 : Read the articles below and discuss what method (NPV or others is the best method to use for capital budgeting purposes . Defend your arguments carefully , and take into account the following among other concers

a ) ease of use

b ) quality of information from such method

c ) quantity of information from such method

Capital budgeting is a required managerial tool . One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return . Therefore , a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives . To do this , a sound procedure to evaluate , compare , and select projects is needed . This procedure is called capital budgeting

A number of surveys have shown that , in practice , the IRR method is more popular than the NPV approach . The reason may be that the IRR is straightforward , but it uses cash flows and recognizes the time value of money , like the NPV . In other words , while the IRR method is easy and understandable , it does not have the drawbacks of the ARR and the payback period , both of which ignore the time value of money

The main problem with the IRR method is that it often gives unrealistic rates of return . Suppose the cutoff rate is 11 and the IRR is calculated as 40 . Does this mean that the management should immediately accept the project because its IRR is 40 . The answer is no ! An IRR of 40 assumes that a firm has the opportunity to reinvest future cash flows at 40 . If...

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