Applying Various Capital Budgeting Methodologies
The objective of a firm is to maximize shareholder wealth. The Net Present Value (NPV) method is one of the useful methods that help financial managers to maximize shareholders' wealth.
Suppose the company that you selected for the Module 1 SLP is considering a new project that will have an initial cash outflow of $125,000,000.
The project is expected to have the following cash inflows: Year Cash Flow ($) 1 2,000,000 2 3,500,000 3 13,500,000 4 89,750,000 5 115,000,000 6 120,000,000 If the project's cost of capital (discount rate) is 12.5%,
what is the project's NPV? Should the project be accepted?
Why or why not?
You may use the following steps to calculate NPV: 1.
Calculate present value (PV) of cash inflow (CF) PV of CF = CF1 / (1+r)^1 + CF2 / (1+r)^2 + CF3 / (1+r)^3 + CF4 / (1+r)^4 + CF5 / (1+r)^5 + CF6 / (1+r)^6 Where the CFs are the cash flows and r = the project's discount rate.
2. Calculate NPV NPV = Total PV of CF - Initial cash outflow or -Initial cash outflow + Total PV of CF r = Discount rate (12.5%) If you do not know how to use Excel or a financial calculator for these calculations, please use the present value tables. Brealey, R.A., Myers, S.C., & Allen, F. (2005).
Besides NPV, there are other capital budgeting methodologies including the regular payback period, discounted payback period, profitability index (PI), internal rate of return (IRR), and modified internal rate of return (MIRR). These methodologies don't necessarily give the same accept/reject decisions as NPV.
If the firm has a requirement that projects are paid back within 3 years, would the project be accepted based off the regular payback period? Why or why not?
Would the project be accepted based off the discounted payback period? Why or why not? What is the project's internal rate of return (IRR)? Based off IRR, should the project be accepted?
Why or why not? Recall the project's cost of capital is 12.5%. What is the project's modified internal rate of return (MIRR)? Based off MIRR, should the project be accepted? Why or why not? What are the advantages/disadvantages of NPV, regular payback, discounted payback, PI, IRR, and MIRR? Present these advantages/disadvantages in a table.