Question

Capital Budgeting and Risk Analysis

• * From the e-Activity, analyze the reasons why the short-term project that you have chosen might be ranked higher under the NPV criterion if the cost of capital is high, while the long-term project might be deemed better if the cost of capital is low. Determine whether or not changes in the cost of capital could ever cause a change in the internal rate of return (IRR) ranking of two (2) projects.
• * From the scenario, take a position for or against TFC’s decision to expand to the West Coast. Provide a rationale for your response in which you cite at least two (2) capital budgeting techniques (e.g., NPV, IRR, Payback Period, etc.) that you used to arrive at your decision.

Answer 1

As we know that cost of capital affects real value of cash inflows from a given project because cash inflows are discounted with the help of given cost of capital. Thus short-term project will be ranked higher under the NPV criteria if the cost of capital is high because in case of high cost of capital, actual discounted cash inlows will be higher in short-term in compare to long-term. As we know that as the time passes then discounted value of cash inflows will be lower that is as a result NPV in short-term will be higher and in long-term will be lower. Thus short-term project will carry higher rank while long-term project will carry lower rank in case of high cost of capital.

So in opposite case when cost of capital is low then long-term project will be better due to low discounted rate for long-term cash inflows.

Yes, it is also true that change in cost of capital will definitely affect IRR decision because cost of capital is the parameter for making decision on the basis of IRR. Thus we can say that an incresae or decrease in cost of capital may affect decision of choosing project from given option because we need to compare cost of capital (minimum required return) and IRR of a project for choosing correct & profitable project.

Hence there is relation between change in cost of capital and IRR and its related decisions.

The cost of capital plays a very key role in capital budgeting decisions.

If the cost of capital is low;the future value of cash flows will be higher and leads to positive NPV.

For example:

Please consider the following

Present value of future cash flows at 11% discount rate is as follows:

Year	Cash flow	Discount rate@11%	Discounted cash flow
0	-18400	1.00	-18,400.00
1	10700	0.90	9,639.63
2	9600	0.81	7,791.36
3	6100	0.73	4,459.71
			21,890.70

Present value of future cash flows at 16% discount rate is as follows:

Year	Cash flow	Discount rate@16%	Discounted cash flow
0	18400	1.00	18,400.00
1	10700	0.86	9,223.40
2	9600	0.74	7,132.80
3	6100	0.64	3,904.00
			20,260.20