NPV and IRR Capital Budgeting Tools - Assignment Example

NPV and IRR Capital Budgeting Tools Question 1. Describe for other members of the strategic planning committee the role that capital budgeting should play in corporate strategic management. Answer. Strategic management analyzes organization’s mission involving company resources and performances in external environment. Capital budgeting consists of two words – “capital” and “budget”. Capital in the context of capital budgeting is fixed asset used in production and service. In this case, fixed asset is one of the aircrafts; European made A220, and American made G435. Budget in the context of capital budgeting is the plan that describes in detail inflows and outflows of revenue and expenses during the project life. The project life for this case is 10 years. Budget will show the company detail plan of cash inflows and outflows during the 10-year operation period of the aircraft. The two words together – capital budget indicates a list of planned long-term investment outlays for projects. In this case, planned investment is to purchase one of two aircrafts and make additional profits from its operation. Capital budgeting is the method used to determine which among long-term capital investment should be chosen. In this case, we are determining one project – purchase of an aircraft. However, we are using two different aircrafts. For simplicity, two different aircrafts are considered as two separate projects. Capital budgeting process helps strategic planning committee pick up the option, which gives higher rate of return considering time value factor of money. This is why it is important in strategic management. Without capital budgeting strategic management team will enter into a wrong selection. Question 2. Explain why the NPV and IRR capital budgeting tools are superior to the accounting rate of return and simple payback techniques for determining the attractiveness of capital investment opportunities.  Answer. Capital budgeting technique uses different tools or approaches to assessing the future investment. Among them are; Payback method, Accounting rate of return method, Net present value method (NPV), Internal rate of return method. Payback method determines the length of time that takes to recover initial cost of an investment. For example, if investment cost is $2,000 and yearly return is $ 500, then payback period is 4 years. This method has two limitations. It does not consider cash inflows for the project beyond payback year, and time value of money. Example: Given below cash flows of two different projects for the same return rate, k = 10 %. Project Investment Cash flow Yr 1 Cash flow Yr 2 A $10,000 $0 $14,500 B $10,000 $ 10,000 $ 2,500 Payback method will select project B, since it pays of in one year. Net present value (NPV) The concept of NPV is included in the following formula, NPV = - Initial Investment + Sum of present value of all cash flows until the end of the project. The basis of this method is in evaluation of time value of future money. NPV measures the additional market value that is created or destroyed as a result of implementation of investment. Example Given below cash flows of two different projects for the same return rate, k = 10 % Project Investment Cash flow Yr 1 Cash flow Yr 2 A $10,000 $0 $14,500 B $10,000 $ 10,000 $ 2,500 NPV A = - 10,000 + 0 + 12,000 / (1+0.1) 2 = - 10,000 + 14,500 / 1.21 = - 10,000 + 11,983 = 1,983 NPV B = - 10,000 + 10,000 / (1+0.1) 1 + 2,500 / (1+0.1) 2 = - 10,000 + 9,090 + 2,066 = 1,156 According to NPV selection method both projects have NPV > 0, but project “A” has higher value. With Payback method project “B” was selected, with NPV method project “A” is selected. Two-year cash flow calculation in NPV method shows that project “A” would maximize the investment. This cannot be said about Payback method. Accounting rate of return This method ignores time value of money. Accounting rate of return is equal to the average net income (after tax) divided by average investment. Where; n Average net income = ,∑ Sum of profit after tax / n, t=1 Average investment = (Initial outlays + Salvage value) / 2. Internal rate of return An investment is undertaken to make profit. In profit calculation rate of return serves an important concept. A rate of return on investment is profit divided by the investment. Internal rate of return is a tool that determines the rate of return from all cash flows of the project considering the time value of money. It determines the value of the rate of return when NPV = 0, which is a break-even point. Project is accepted if IRR is higher than the project financing cost. We have discussed four different tools for capital budgeting. The payback method and accounting rate of return method do not consider the time value of money. Payback method does not consider timing and risk of cash flows, which potentially could lead to wrong evaluation. Both NPV and IRR consider time value factor of money in considering return and investment maximization. This is why NPV and IRR are superior in capital budgeting. Question 3. Use the Capital Asset Pricing Model (CAPM) to identify the cost of common stock Answer. Capital Asset Pricing Model (CAPM) determines risk and expected return used in pricing common stock. The model has the following parameters: Rf = Risk free rate, Rm = Expected market return β = Beta of the security In the given assignment, Rf = 10-year Treasury Bond return = 6.2 % Market risk premium = 7 % Rm = 6.2 % + 7 % = 13.2 % (“Risk Premium”) β = 1.40 Cost of common stock = Rf + β (Rm – Rf) = 6. 2 % + 1.40(13.2% - 6.2 %) = 0.062 + 1.4 (0.132 – 0.062) = 0.16 = 16 % Question 4. Calculate the weighted average cost of capital (WACC) for the firm’s existing capital structure. Answer. Preferred Stock 32 % Cost of preferred stock = 12 % Common Stock 58 % Cost of common stock = 16 % Long Term Debt 10 % Cost of long term debt = 13.53 % Cost of long term debt calculation Marginal tax rate = 35 % (Perez) After tax cost of debt = 8.8 % After tax cost of debt = before tax cost of debt x (1 – marginal tax rate) (“After Tax Cost of Defination”) Before tax cost of debt = (after tax cost of debt ) / (1 – marginal tax rate) = 8.8 % / (1-35%) = 0.088 / (1-0.35) = 0.088 / 0.65 = 0.1353 = 13.53 % WACC calculation Funds Weight Cost Weighted Cost Debt 0.1 13 % 1.3% Preferred Stock 0.32 12 % 4.2 % Common Stock 0.58 16 % 9.28 % 14.78 % WACC = 14.78 % Question 5. Calculate the net present value (NPV) for each plane model using the company’s WACC as the hurdle rate. Answer. Given: A220 G435 Cost 90,000,000 128,000,000 OCF 30,000,000 25,000,000 Cost Yr 5 115,000,000 0 Project life 10 years 10 years Salvage value 500,000 500,000 WACC = 14.78 % NPV will be calculated for 10 years for both planes. Project with plane A220 involves a new investment on the 6th year. That is why; cash flow for the 6th will be adjusted with the inclusion of 115,000,000 as new investment. This value will also be discounted. Net Present value for A220 14.78% Present Value Cash flows PV Factors Year 1 30,000,000 0.87123 26,136,958 Year 2 30,000,000 0.75905 22,771,352 Year 3 30,000,000 0.66130 19,839,129 Year 4 30,000,000 0.57615 17,284,482 Year 5 30,000,000 0.50196 15,058,793 Year 6 -85,000,000 0.43732 -37,172,486 Year 7 30,000,000 0.38101 11,430,302 Year 8 30,000,000 0.33195 9,958,444 Year 9 30,000,000 0.28920 8,676,114 Year 10 30,500,000 0.25196 7,684,890 Working capital return 0 0.25196 0 Total 101,667,978 Investment 90,000,000 -90,000,000 npv 11,667,978 Net present value for G435 14.78% Present Value Cash flows PV Factors Year 1 25,000,000 0.87123 21,780,798 Year 2 25,000,000 0.75905 18,976,127 Year 3 25,000,000 0.66130 16,532,607 Year 4 25,000,000 0.57615 14,403,735 Year 5 25,000,000 0.50196 12,548,994 Year 6 25,000,000 0.43732 10,933,084 Year 7 25,000,000 0.38101 9,525,252 Year 8 25,000,000 0.33195 8,298,703 Year 9 25,000,000 0.28920 7,230,095 Year 10 25,500,000 0.25196 6,425,072 Working capital return 0 0.25196 0 Total 126,654,467 Investment 128,000,000 -128,000,000 npv -1,345,533 Question 6. Recommend which plane should be purchased and justify your recommendation Answer. A220 plane should be purchased. The decision is based on the fact that for G 435 , NPV < 0, while for A 220, NPV > 0. Question 7. Discuss the need to manage implementation of the project so that the higher returns can be realized.  Include the strategic management keys to protecting the project from competitive forces that would erode the earning power of the project and jeopardize realization of the projected rate of return on the investment. Answer. Higher returns from investment require careful planning and organized effort of the mangers of the company. A successful accomplishment of the project requires developing of a plan, which defines projects goals, objective, and determines steps in achieving the goals. Managing the implementation of the project includes total control of operations, receiving of objective information on performance, means to imply recovery actions where necessary. The strategic management keys (“Strategic Management Process”) establish an organization’s strategy to achieve better performance from a capital investment. It appraises the business in which the corporation is involved, appraises its competitors and reassesses strategy to meet all current and future competitors. Strategic management system has four steps; environmental scanning, strategy formulation, strategy implementation, and strategy evaluation. These four steps help mangers collecting and analyzing information, develop operating strategies, making the selection and implementation of organizational objectives. These steps help the company in protecting project from competitive forces. References After-tax Cost of Debt Definition. (n.d.). Accounting Education. Retrieved from http://www.svtuition.org/2012/01/after-tax-cost-of-debt-definition.html Perez, W. (n.d.). Tax Rate for 2102 Tax Year. About.com. Retrieved from http://taxes.about.com/od/Federal-Income-Taxes/qt/Tax-Rates-For-The-2012-Tax-Year.htm Risk Premium. (n.d.). investopedia.com. Retrieved from http://www.investopedia.com/terms/r/riskpremium.asp#ixzz28DPNXWKp Strategic Management Process. (n.d.) Management Study Guide. Retrieved from http://www.managementstudyguide.com/strategic-management-process.htm Read More