**Marti Pletcher**

Capital Budgeting Analysis

FNT1 - 319.1.3-01, 2.1-04, 2.5 - 05

Capital Budgeting Analysis

FNT1 - 319.1.3-01, 2.1-04, 2.5 - 05

Net Cash Flow

(minus) Depreciation

Project Analysis - NPV basis

Net Present Value 12% Present

Cash Flows PV Factors Value

year 1 629,375 0.893 561,941.96

year 2 629,375 0.797 501,733.90

year 3 704,375 0.7118 501,360.21

year 4 704,375 0.6355 447,643.05

year 5 779,375 0.5674 442,238.31

year 6 779,375 0.5066 394,855.63

year 7 929,375 0.4524 420,402.05

year 8 929,375 0.4039 375,358.98 Working Capital Return 220,000 0.4039 88,854.31

Salvage Return 60,000 0.4039 24,232.99

Building restoration costs (140,000) 0.4039 (56,543.65)

total 3,702,078

Investment 3,620,000

Net Present Value

$82,078

Project Analysis - IRR basis

Internal Rate of Return

Cash Flows

Investment -3,620,000

Year 1 629,375

Year 2 629,375

Year 3 704,375

Year 4 704,375

Year 5 779,375

Year 6 779,375

Year 7 929,375

Year 8 + Working Cap + SV - Remodeling 1,069,375

Internal Rate of Return Using Excel 12.59%

**Explanation of Capital Budgeting Analysis Methods**

B4: Accounting Rate of Return vs IRR

B5 Significance of Payback period

B6 WACC use in Capital Budgeting with NPV

B7 WACC use in Capital Budgeting with IRR

Yr 2 with Yr 2 without Dollar Amt

Depreciation Depreciation Difference

Expected annual sales of new product $3,100,000 $3,100,000

Expected costs of new product

Cash expenses $2,400,000 $2,400,000

Depreciation expense $417,500 0

Income before taxes $282,500 $700,000 $417,500

Income tax at marginal rate $70,625 $175,000 $104,375

Net income $211,875 $525,000 $313,125

Net cash flow for one year $629,375 $525,000

($104,375)

B.1

*Depreciation was calculated on a straight line basis by dividing the total equipment cost by the number of useful years the product would have.

Depreciation causes net cash flow to increase because it is added back into the CF equation at a before tax rate, thus increasing cash flow.

Recommendation

:

Accepted

- NPV is positive, based upon the cash flow analysis and the Net Present Value at year 8, the investor should go ahead with project because it has proven that it will yield a positive return.

B2

Net Present Value is found by subtracting the present value of cash inflows minus cash outflows and is used for capital budgeting projects to analyze profitability

Rule: ACCEPT If

IRR > Required Rate of Return (Cost of Capital)

IRR

12.59%

>

Cost Of Capital

12%

Recommendation = ACCEPT

Project recommendation

ACCEPT

IRR > Cost of Capital

Project Recommendation

Accept

NPV is Positive

**B3**

ARR vs IRR

Payback Period

Payback Period

Year 0 -3,620,000

Year 1 -2,990,625

Year 2 -2,361,250

Year 3 -1,656,875

Year 4 -952,500

Year 5 -173,125

Year 6 606,250

Year 7 Year 8

WACC used with NPV

For Capital Budgeting

WACC used with IRR

For Capital Budgeting

B4

Accounting Rate of Return

"The average annual income from a project divided by the initial investment" (investopedia)

Internal Rate of Return

"The interest rate at which the present value of the dollars invested in a particular project would equal the present value of the cash inflows from the project." (investopedia)

Difference

IRR is the only method that uses the time value of money to account for the future growth of the money

ARR uses accounting profits while IRR uses cash inflows

B5

Definition: The length of time that it takes for a Project to recoup its initial cost out of the cash receipts that it generates.

- Should NOT be sole criterion for analyzing an investment because it does NOT consider time value of money. IRR and NPV are better methods of analysis

Payback Period

5 years

3 Months

B6

B7

Uses with NPV:

Represents the average risk of project

Used to find NPV factors that help adjust cash flows to present values

To find NPV Factors

1/(1+Wacc)^t

WACC is the average weighted cost of all sources of capital.

WACC used in conjunction with IRR to determine whether a project should be accepted or rejected

Accept If IRR > WACC

Reject if IRR < WACC

Payback period is used in capital budgeting analysis to determine how long it will take to break even which allows investors to know how long they need they need to get a loan for.

Disadvantages:

1. Does not take into consideration the time value of money

2. Does not consider the cash flows after payback period.

3. Should not be used as stand alone criteria for investment decision

Advantages:

1. Simplicity of formula

2. Measures risk inherent in a project.

3. Is good for companies that have liquidity problems.