Question

contains a list of available investment projects and their respective cash flows. Using a cost of capital of 10%, please answer the following questions: 1- Find the payback period, net present value and internal rate of return for each project. (Using excel to do this will save you a lot of time). 2- Based on the results, identify conflicts in ranking the above projects based on the IRR and NPV approaches, i.e. a project that has a higher rank using IRR but a lower rank using NPV and vice versa. You should also provide a discussion of what caused the conflict? 3- Provide a discussion of the advantages and disadvantages of all the capital budgeting techniques covered in this course, and identify methods to overcome the disadvantages (if available). 4- Provide a brief discussion (a small paragraph) of the practicality (uses in real life) of the different capital budgeting methods.
(i gave everything i got from the teacher :D) A cash flow empty

Project A	(1,000,000)	$ 200,000	$ 200,000	$ 200,000	$ 200,000	$ 200,000	$ 200,000	$ 200,000	$ 200,000	$ 200,000	$ 200,000	$ 400,000
Project B	(1,000,000)	$ 500,000	$ 500,000	$ 500,000
Project C	$     (80,000)	$      1,040	$      9,456	$    11,405	$    18,567	$    47,453	$      6,394	$    45,727	$    51,933	$    85,625
Project D	$   (400,000)	$      4,161	$    37,824	$    45,618	$    74,269	$ 189,812	$    25,577	$ 182,907	$ 207,733	$ 342,499
Project E	$     (17,000)	$    16,000	$    16,000	$ (16,000)	$    16,000	$ (52,000)
Project F	$        (5,000)	$      2,000	$      2,000	$      2,000	$      2,000	$      2,000
Project G	$        (5,000)	$             -	$             -	$             -	$             -	$    15,000
Project H	$     (20,000)	$      7,000	$      7,000	$      7,000	$      7,000	$      7,000

Answer 1

Based on the given information, the NPV, IRR and Payback calculations are worked out in excel and provided below:

Table 1: Computation of IRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%); The IRR shall not be able to arrive in case of Project E, where there are negative cash flows in total;

Table 2: Computation of Net Present Value (NPV) based on the Disounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) = 1/(1+10%) = 0.9091; Year 2 = Yeaar 1 factor/(1+discounting factor %) = 0.9091/(1+10%) = 0.8264 and so on;

Next, the cashflows need to be multplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;

Table 3: Computation of Pay Back Period: Here, the period is computed for each project, based on cumulative discounted cash flows: If the cumulative value is less than or equal to zero, the period is considered as 12 months (it means that the net cumulative cash flow has not yet paid back the initial invesment); Once the value turns postive in a particular year, the period for such year is observed at a proportion of actual discounted cash flow to the cumulative CF; This gives the period less than 12 months in such year; Once this is computed, total of all the years is taken and divided by 12, to arrive at the Payback period in no.of years.

Table 4: This table provide the comparative analysis of the various techniques used on the all these Projects; It may be observed that the ranking pattern between the NPV and IRR shall differ; This is due mainly the reason that these all are the mutually exclusive projects with different sizes and the difference in the timing of the cashflows;

Eg of Project A: As per NPV, it generates the highest amount of cashflows and is ranked 1, however, as per IRR, it is ranked at 6; This is due to the facts that there are other projects with lower initial investment which shall give benefits much earlier, however, in small value, like Project F (ranked 1 as per IRR); Hence, it is required to assess on the requirement of the project, Capital invesment proposed, Risk appetite on the Pack back period, etc, to evaluate the appropriate project.

Advantages and Disadvantages:

IRR: Advantage: This is very simple to use on various projects to assess based on the cost of capital / Hurdle rate / discounting factor; The IRR provides any small business owner with a quick glance of which projects would generate the greatest potential cash flows;

Main disadvantage of IRR is that it does not consider key factors like duration of the project duration, future costs or the size of a project. The IRR simply compares the project's cash flow to the project's current outflows, excluding all other factors;

NPV: Key advantage is that cash flows from future periods is discounted back to the present to find their value as at present date. The NPV method gives the value indicates how much value the project will create for the company. Project Managers can understand how much a project will contribute to their value, in value terms.

Disadvantage is that NPV takes into consideration the only cash flows of a project. It fails to include other critical costs that can have an impact on the true value of the investment. These costs include opportunity costs and any other costs, etc. Also, dependency on the cost of capital for PV of future cash flows ignores the sensitivity of the discounting factor;

Payback Period: This is mainly useful for any business that is in to making relatively small investments, and so does not need to engage in more complex calculations that take other factors into account. It establishes a comfort to the project evaluators on when their initial outlay shall be covered.

Key disadvantages is that it ignores any cash flows post the Payback period; Incase of any negative cash flows post payback, this technique completely fails in assessing the same (Project E above); Also, this technique is not helpful in assessing the profitability of a project.

While there are other Capital Budeting techniques like Breakeven analysis, Constraint analysis, the above three are key techniques used for any project evaluations;

Real use applications:

These techniques are used mainly in strategic investments which include major CAPEX investments including long term cash flows, Process changes, Business Valuations based on the expected net cashflows from the Business, Investments based on the expected return on the same (basic computations), etc; These help in assessing the profitability of the existing business by investing further in its operations, etc or rather by external business acquisitions.