BUS FPX 3062 Assessment 5 Capital Budgeting

BUS FPX 3062 Assessment 5 Capital Budgeting

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Capella University

BUS-FPX3062 Fundamentals of Finance

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Capital Budgeting: Evaluating Projects with NPV, Payback Period, and IRR

Capital budgeting is essential for businesses to assess potential investment opportunities. This guide will walk you through the calculations for NPV, payback period, and IRR using the provided data. Each section includes formulas suitable for Excel to help streamline the calculation process.

1. Net Present Value (NPV) for Project Y

Cash Flows:

Formula for NPV:

To compute NPV in Excel:

=NPV(0.10, B2:B5) + B1

Where:

• B1 is the cash flow at Year 0 (-$8,000)
• B2:B5 are cash flows from Years 1 to 4

NPV Calculation:

Given the cash flows, the calculated NPV is -$139.18.

Recommendation:

Since the NPV is negative, the firm should reject Project Y.

2. Payback Period for Project X

Cash Flows:

Payback Period Calculation:

The payback period is calculated by accumulating cash flows until the initial investment is recovered.

Excel Formulas:

To compute cumulative cash flows and payback period in Excel:

1. Cumulative Cash Flow (C2 formula):

   =B1
   

2. Cumulative Cash Flow for Years 1 to 5 (C3 formula):

   =C2 + B2
   

3. Continue this for each year.

4. Payback Period Calculation (assuming Cumulative Cash Flow is in column C):

   =IF(C5 < 0, "", YEAR(B1 + (C4/B4)))
   

Result:

The calculated payback period is 3.2 years. Since this is less than the maximum allowable payback of 4 years, the firm should accept Project X.

3. NPV and IRR for Two Mutually Exclusive Projects

Cash Flows:

NPV Calculation:

To calculate NPV for both projects in Excel:

=NPV(0.10, B2:B6) + B1  // For Project A
=NPV(0.10, C2:C6) + C1  // For Project B

IRR Calculation:

To calculate IRR:

=IRR(B1:B6)  // For Project A
=IRR(C1:C6)  // For Project B

Results:

• Project A: NPV = $8,391.86, IRR = 16.99%
• Project B: NPV = $10,710.61, IRR = 14.75%

Recommendation:

Since Project B has a higher NPV, it should be accepted over Project A.

4. NPV and IRR for Los Angeles Lumber Company Project

Cash Flows:

• Initial Investment: $1,000
• Cash Inflows: $300 annually for 5 years

Formulas:

1. NPV:

   =NPV(0.12, B2:B6) + B1
   

2. IRR:

   =IRR(B1:B6)
   

Results:

• IRR = 15%
• NPV = $72.71

Recommendation:

Since the IRR exceeds the cost of capital, the project should be accepted.

5. NPV and MIRR for a Project with Cash Inflows

Cash Flows:

• Initial Cost: $65,000
• Annual Cash Inflows: $12,000 for 9 years

Formulas:

1. NPV:

   =NPV(0.10, B2:B10) + B1
   

2. IRR:

   =IRR(B1:B10)
   

3. MIRR:

   =MIRR(B1:B10, finance_rate, reinvest_rate)
   

4. Assume finance_rate = 10% and reinvest_rate = 12%.

Results:

• IRR = 12%
• MIRR = 11%

Recommendation:

Both the IRR and MIRR are favorable; therefore, the project should be accepted.

6. Comparing Capital Budgeting Methods: NPV, IRR, and MIRR

When comparing capital budgeting methods:

• NPV provides a clear picture of the total cash value of a project upon completion, indicating whether a project adds value.
• IRR reflects the rate of return relative to the initial investment, helping compare against the required return.
• MIRR accounts for both cash flows and the cost of capital, offering a more accurate assessment over time by addressing some IRR shortcomings.

BUS FPX 3062 Assessment 5 Capital Budgeting

In conclusion, while each method has its strengths, NPV is generally preferred due to its direct relationship with value addition. However, IRR and MIRR can also provide valuable insights, especially when assessing projects against varying financial constraints.