1. The most popular capital budgeting techniques used in practice to evaluate and select projects are payback period, net present value (NPV), Profitability Index (PI), and internal rate of return (IRR).
2.Payback period is the number of years required for a company to recover the initial investment cost. The shorter the payback period, the better the project.
3. Net Present Value (NPV) technique: NPV is found by subtracting a project’s initial cost of investment from the present value of its cash flows discounted using the firm’s weighted average cost of capital. It shows the absolute amount of money in dollars that the project is expected to generate.
Decision Criteria of NPV
If NPV > 0, accept the project
If NPV < 0, reject the project
The decision rule for mutually exclusive project is to select the project with the highest NPV.
4. Internal Rate of Return (IRR) is the intrinsic rate of return the project is likely to generate. The IRR is the discount rate or the rate of return that will equate the present value of the cash outflows with the present value of the cash inflows (i.e., NPV = 0).
Decision Rule:
Accept the project if IRR > cost of capital
Reject the project if IRR < cost of capital
5. Profitability Index is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment. Accept if PI > 1.0 and reject if PI < 1.0.
Exhibit 1: The expected cash flows in US$ from the project in Ohio and North Dakota.
Year
Cash flow (Ohio)
Cash flow (ND)
0
(2,200,000)
(2,450,000)
1
450,000
350,000
2
558,000
185,000
3
562,000
205,000
4
587,000
300,000
5
600,000
370,000
6
625,000
590,000
7
630,000
500,000
8
685,000
483,000
9
690,000
480,000
10
692,000
620,000
The company’s policy is to select projects using NPV technique and IRR. The cost of capital is 12% for the Ohio project and 10% for ND project.
1. You have been hired as a financial consultant to help evaluate the project. Baldwin Inc. wants you to do the following:
a. Calculate the payback period (PBP) for the two projects.
b. Calculate the profitability Index (PI) for the two projects.
c. Calculate the Internal Rate of Return (IRR) for the two projects.
d. Calculate the Net Present Value (NPV) for the two projects.
e. Use the NPV technique to recommend which investment project it should accept, assuming the cost of capital of financing the Ohio project is 12% and 10% for the North Dakota project?
2. Lok knows how bad forecast can ruin capital budgeting decisions. If the cost of capital changes from 12% to 13% for Ohio project and remains the same for ND project, does the company have to pursue the project?
3. Lok wants to analyze the risk of the project using sensitivity analysis and Monte Carlo simulation.
a. Explain to Baldwin Inc. how the two risk analysis models can be used to analyze risk of the project.
4. Lok has estimated the fixed costs (including depreciation) of the Ohio project to be $6 million, sales price is $2,000, and the variable cost is $800, giving a contribution margin of $1,200. What is the accounting profit break-even quantity for this project?
5. Baldwin Inc. wants to know the likely effect of the capital budgeting decision on its stock price (increase, decrease, no change, or not sure). Choose one and explain why.