Capital Budgeting Mini-Case There Are

Capital Budgeting Mini-Case There are three different major parts of company financials to be presented to the public and the investors for the latter to monitor company financial performance: income statement, balance sheet and cash flow statement. Balance sheet is a summary of all company assets which must be equal to liabilities and equity lefts to the investors at a specific point in time.

Income statement assesses company financial performance by outlining company revenues and expenses from operating and non-operating activities, and stating whether profit or loss was incurred in a financial year. Profit from operating activities reveals to the investors and analysts the company abilities to generate profit as net of revenues and expenses, from the company core activities. On the contrary, profit from non-operating activities reveals the ability of the company to generate profit from not major to the company business segments.

Cash statement is different from the income statement in the way that the former does not include sales and income received on credit. 5-year projected income state for the both companies will include revenues, deducted for expenses, deducted for depreciation to arrive at taxable income. Tax payable at 25% rate for both companies is then calculated. Total net income is the amount left after deducting expenses, depreciation and tax payable from the revenues of the company.

For a 5-year cash flow statement, it is not necessary to deduct depreciation as this statement reflects as close as possible the actual cash paid and received by the company. For this reason, the same steps as in income statement calculations are carried out up to the point of calculating the tax to be payable. But when arriving at net cash flow, revenues are adjusted for revenues and taxable income. Net present value is the discounted value of the net cash flow by the discount rate.

For the company A, alue at the discount rate of 10% is $271,000 PV of project cash flows, or NPV equal to $20,979 if deducting initially invested capital. For company B, the net cash flows are discounted at 11% discount rate annually and the present value of the cash flows is approximately $271,500 and the NPV if $21,500 for the second project, is only marginally higher than for the company A. Thus, all the other risk factors being equal or reflected in the cash flows and the discount rate, the company B.

is more profitable as a potential investment. It is vital to correctly estimate the discount rate to be applied to valuation of investment projects based on their risks, because the higher is the discount rate, the lower is the NPV and thus the lower attractive is the project. The Internal Rate of Return is the discount rate which equates present values of net cash flows to zero, or the discount rate which makes the NPV of the project zero.

If the internal rate of return on the cash flows is higher than the minimum rate of return required by the investor, the investment meets the selection criteria and should be considered. If the IRR is lower than the required rate of return, the investment will not be profitable. For company A, the IRR on the cash flows assuming that the company purchase price is $250,000, equals to 13,052%. Assuming the B.

company purchase price is equal to that of the company A, the IRR for company A cash flows is 14,305% and is higher than that for company A. As the discount rate used for valuation of company A cash flows is 10%, the implication that this is the investor's sentiment of risk associated with this company. The IRR for company A cash flows is higher than the minimum required rate of return, thus the investment should be undertaken.

For company B, the risks associated with cash flows are higher than that for company A, and are in the order of 11%, but nevertheless, the IRR on the cash flows is higher than the minimum required rate of return of 11% making this investment also attractive. As these two projects are mutually exclusive, and considering only IRR investment selection criteria, purchase of company B. with IRR of 14,305% is more profitable investment than purchase of company A with IRR of 13,052%.

The IRR method does not consider the size of the initial investment necessary to achieve this rate of return on the cash flows and thus is not a perfect investment decision tool, as typically higher initial investment require much higher minimum rates of return to motivate investor sacrifice this capital and enter into the project. The payback period reflects the number of years it takes for a specific cash flow from investment to amount to initial investment into this project.

If the cash flows form the project are constant in the time, the payback period formula is simply the result or the ratio of initial investment or capital spent to annual cash flows. In the subject example, the cash flows are not constant in time, and the capital initially spent is subtracted from net annual cash flows to estimate the year in which the cash flows will break even.

For company A, the payback period is 4 years, where already in the 4th year the company will achieve $28,174 above the initially spent amount. For company B, the payback period is also 4 years, and in the 4th year of operation the company will achieve $42,236 above the initially spent amount. Considering the fact that both company A and B. require the same initial investment, company B. is more profitable and has better payback period.

The payback period investment selection criteria is flawed by the fact that it does not consider cash flows after the cut off period, which can be much higher than for an investment project with lower payback period, but not as profitable in the longer term. Also, payback period does not consider time value of money and thus.