Capital Budgeting Case Student Name University of Phoenix QRB501/Quantitative Reasoning for Business Date Professor Name Capital Budgeting The authors of this paper will analyze and interpret the answers to the Capital Budgeting Case Study presented in Week 6 material of the Quantitative Reasoning for Business course. The paper presents the rationale behind the Net Present Value (NPV) and Internal Rate of Return (IRR) results, describes the relationship between the two of them and explains the reasons behind the acquisition recommendation (e) in the Microsoft Excel spreadsheet.
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Analyzing the Results The case study presents two corporations (A and B) with different revenue values and expenses as well as variable depreciation expenses, tax rates and discount rates. Members of the team calculated both corporations’ cash flows, NPV and IRR values using a Microsoft Excel spreadsheet. The net present value (NPV) of an investment proposal is equal to the present value of its annual free cash flows less the investment’s initial outlay. Whenever the project’s NPV is greater than or equal to zero, we will accept the project; whenever the NPV is negative, we will reject the project.
Keown, 2014. p. 310) On the other hand Keown (2014) points out that “the internal rate of return is defined as the discount rate that equates the present value of the project’s free cash flows with the project’s initial cash outlay. ” In effect, the NPV method implicitly assumes that cash flows over the life of the project can be reinvested at the project’s required rate of return, whereas the use of the IRR method implies that these cash flows could be reinvested at the IRR.
The better assumption is the one made by the NPV—that the cash flows can be reinvested at the required rate of return because they can either be returned in the form of dividends to shareholders, who demand the required rate of return on their investments, or reinvested in a new investment project. (Keown, 2014. p. 317) Based on the team members’ calculations, Corporation A had an NPV value of $20,979. 20 with an IRR value of 13. 05%. Corporation B had an NPV value of $40,251. 47 with an IRR value of 16. 94%. Both corporations had a positive NPV result, which means both companies created value; however Corporation B created almost twice as much value as Corporation A because of the significant difference in cash flow. Also, Corporation B’s IRR value exceeded Corporation A’s rate by 3. 89%. The company could only acquire one of the corporations with the initial layout of $250,000 and the decision had to be based on the NPV and IRR values.
Based on the analysis shown in the Microsoft Excel spreadsheet it is recommended that the company purchase Corporation B because their NPV and IRR rates are higher and it is a better investment option. Investing in this corporation adds more value to the bottom line of the organization. Relationship between NPV and IRR As previously discussed, if the NPV results is positive is a good sign that a project should be accepted; on the contrary with a negative result a high possibility of rejection might be shown because cash flows will not be enough to demonstrate profitability traits.
Another way to think of an IRR is the growth expected on a business, thus, a higher IRR value would provide better chances of a strong growth. Recapping this case study, we can conclude that capital budgeting is the process that company uses to determine possibilities of investing on new growth opportunities such as acquisitions or expansions. Net present value (NPV) is an investment measure that tells an investor whether the investment is achieving a target yield and help companies determine how much money is needed for investment.
To do this, acquiring companies needs to estimate future cash flows, cost of capital and discount rates to determine de present value of the investment, so decisions are well taken. In this particular case, company B showed better NPV and higher IRR resulting to be more solid than company A and a more profitable company to invest. Reference Keown, A. (2014). Foundations of Finance: The Logic and Practice of Financial Management (8th ed. ). New York, NY: Pearson Education.