In: Accounting
You're a recent graduate of Champlain College and landed a great job in New York as a junior financial analyst for Chuck Schwable, a leading investment firm whose name bears no resemblance to a well known investment firm. Schwable has recently been hired by Giggle, a leading IT corporation, to provide some capital budgeting recommendations for a major building project in downtown Manhattan. This is it...it's your big chance to make a great first impression and show off the skills you gained in your MGMT 240 finance class.
The senior financial analyst in your office asks you to provide a general synopsis of three common capital budgeting techniques: NPV, IRR, Profitability Index, and the Payback Period. Your synopsis will be presented to a small group of very important Giggle stakeholders who know nothing about capital budgeting.
For your synopsis (use fictitious data, if applicable):
NPV - Net present value method
Net present value is a method to analyse profitability of the investment decisions. It deals with finding the present value of future earnings from an investment
The formula to find the net present value is :
present value of cash inflows minus present value of cash out flow
if the the NPV is positive , then investment decision is acceptable
The present value is found out by multiplying the annual cash inflows or outflows by the present value factor
Example :
Mr A invests $ 100,000 to earn $ 12,000 every year for 5 years and the cost of capital is 10 %
Year |
Annual Cash Flows ($) |
Present Value Factor @ 10% |
Present value of annual cash flows ($) |
1 | 12000 | 0.909 | 10908 |
2 | 12000 | 0.826 | 9912 |
3 | 12000 | 0.751 | 9012 |
4 | 12000 | 0.683 | 8196 |
5 | 12000 | 0.621 | 7452 |
6 | 12000 | 0.564 | 6768 |
7 | 12000 | 0.513 | 6156 |
8 | 12000 | 0.467 | 5604 |
9 | 12000 | 0.424 | 5088 |
10 | 12000 | 0.385 | 4620 |
TOTAL | 73716 |
NPV = $ 100,000 - $ 73,716
= - 26,284
as the NPV is negetive the investment is not financialy viable
Benefit of NPV technique:
1. it can be used to compare similar investment decisions to find the most profitable one.
2. it is based on the cost of capital and return to cost concept
3 it gives future projections and time value of the present investments.
it is further explained with an example :
Profitability index:
Profitability index is the ratio of the present value of the future cash flows to the initial investment.
It analyses the cost and benefits of an investment decision.
The minimum profitability index to select a investment decision is 1
formula :
profitability index = NPV of cashflows / initial investment
example:
in the light of the above example the profitability index is:
$ 73,716 / $ 100,000
= 0.737
as the ratio is less than 1 it is not financialy viable
Benefits of profitability index:
1. It is the best to rank investment projects in case of limited capital.
2. It compares the investment with regard to the time value of money and future risk.
3. It is beneficial to find the investment decisions which are value creators.
Payback period method:
The payback period is the method of calculation by which the time taken to recoup the investment is found out.
Shorter payback periods are more preferable than longer payback periods
formula:
When the cash flows are uniform-
Payback Period = Amount invested / Annual cash flows
example:
in the light of the above example the payback period of Mr A investment is
$ 100,000 / $ 12000 = 8.33 years
Benefits of Payback period:
1. It helps in calculating how fast the investments can be regained and the risks relating to it
2. it is a very simple process to analyse best investment proposal.
3. Varying payback periods are a good tool for the risk analysis.
IRR - Internal rate of return method
IRR is similar to NPV method , this method is usually used evaluate the investment decision that has different time periods
In this method the net present value of the project is set to zero .
formula :
Present value of all cash flows - Present value of initial cash outflow = 0
the higher the IRR the more beneficial are the investment proposals
Benefits of IRR
1. It is more beneficial in evaluating different proposals with varying time period
2, more comprehensive study
3. IRR is found out through the trail and error method
4. IRR in turn gives the break even rate of return