Homework SourseCapital Budgeting Data A Suppose the company is considering
Capital Budgeting Data A. Suppose the company is considering a potential investment project to add to its portfolio. Calculate the following items: 1. The net present value (NPV) of the project 2. The internal rate of return (IRR) of the project B. What are the implications of these calculations? In other words, based on each of the calculations, and being mindful of the need to balance portfolio risk with return, would you recommend that the company pursue the investment? Why or why not? Be sure to substantiate your claims. C. What is the difference between NPV and IRR? Which one would you choose for evaluating a potential investment and why? Be sure to support your reasoning with evidence.
| Capital Budgeting Example Set-up | ||
| Initial investment $65,000,000 | ||
| Straight-line Depreciation of 20% | ||
| Income Tax @35% | ||
| WACC of 8% approximately. (HD WACC was about 8.83%) | ||
| Cash Flow (which in this case are Sales Revenues) are as follows: | ||
| CF1: $50,000,000 | ||
| CF2: $45,000,000 | ||
| CF3: $65,500,000 | ||
| CF4: $55,000,00 | ||
| CF5: $25,000,000 | ||
| Operating Costs | ||
| CF1: $25,500,000 | ||
| CF2: $25,500,000 | ||
| CF3: $25,500,000 | ||
| CF4: $25,500,000 | ||
| CF5: $25,500,000 |
Solution
Initial investmnet = 65,000,000
Annual Depreciation = 0.2 * 65,000,000 = 13,000,000
Operating cash flow for year 1 = ( cash flow - operating costs - depreciation)( 1 - tax) + depreciation
Operating cash flow for year 1 = ( 50,000,000 - 25,500,000 - 13,000,000)(0.65) + 13,000,000
Operating cash flow for year 1 = 20,475,000
Operating cash flow for year 2 = 17,225,000 ( from the data provided)
Operating cash flow for year 3 = 30,550,000
Operating cash flow for year 4 = 23,725,000
Operating cash flow for year 5 = 4,225,000
NPV = Present value of cash inflows - present value of cash outflows
NPV = -65,000,000 + 20,475,000 / ( 1 + 0.08)1 + 17,225,000 / ( 1 + 0.08)2 + 30,550,000 / ( 1 + 0.08)3 + 23,725,000 / ( 1 + 0.08)4 + 4,225,000/ ( 1 + 0.08)5
NPV = $13,291,616.74
IRR is the rate of return that makes NPV equal to 0
-65,000,000 + 20,475,000 / ( 1 + R)1 + 17,225,000 / ( 1 + R)2 + 30,550,000 / ( 1 + R)3 + 23,725,000 / ( 1 + R)4 + 4,225,000/ ( 1 + R)5 = 0
Using trial and error method, i.e, after trying various values for R, lets try 16
-65,000,000 + 20,475,000 / ( 1 + 0.16)1 + 17,225,000 / ( 1 + 0.16)2 + 30,550,000 / ( 1 + 0.16)3 + 23,725,000 / ( 1 + 0.16)4 + 4,225,000/ ( 1 + 0.16)5 = 0
0 = 0
Therefore IRR is 0
Since NPV is a positive number and IRR is greater than cost of capital of 8%, we will accept the project. These numbers will create value to the company.
Difference between NPV and IRR:
Net present value (NPV) discounts the stream of expected cash flows associated with a proposed project to their current value, which presents a cash surplus or loss for the project. The internal rate of return(IRR) calculates the percentage rate of return at which those same cash flows will result in a net present value of zero
We woufl choose NPV to evaluate a potential investment.
A positive NPV will create value to the company
