Financial Management Principles - Essay Example

There a different capital budgeting valuation method that can be used to calculate how profitable a project will be. Four of these methods are payback period, net present value, internal rate of return and modified internal rate of return. The five basic steps on a capital budgeting model are: The Chief Financial Officer of Strident Marks wants to determine the viability of a project he wants to pursue. He applied the four capital budgeting valuation methods to establish financial metrics to arrive a decision.

Exhibit A shows the mathematical calculations he performed to arrive at the results. The data he had from the project was an initial investment of $10,000. The project would generate $7500 each year for three consecutive years. The project’s discount rate was 10%. The revenue projections made the assumption that revenue inflows would be generated at the beginning of the year. The payback period analysis concluded that the return of original investment can be achieved in 1.33 years. The payback method is a simplistic method which only calculates the amount of years it takes to recover the original value of cash or assets invested in the project.

If two or more projects are compared the project with the lowest time to recover the initial investment would be chosen. A major drawback of this method is that it does not take into consideration time value of money. The net present value (NPV) method application resulted in a value of $8651. This value is a good sign since the general rule to follow is that only projects whose NPV results in a positive total can be accepted. When comparing various projects a manager chooses the one with the highest NPV total.

A firm that undertakes a project with a positive NPV improves the position of the stockholders because the project will increase the value of the company (Besley & Brigham). The internal rate