Question

XYZ telephone company has a capital Budget of $5,000,000 for the fiscal year. The total number of capital projects submitted was $7,000,000. The CFO and CEO have made a statement that only capital projects that prove worthy will be approved. The projects will be approved if they have a 3 year payback, positive NPVof 12%; and IRR of 12%. The companies WACC is 10%. The equipment purchases center on the 5th Generation Router and communication devices. What do you think?

Answer 1

XYZ company's budget $5 million is lower than the sumitted projects worth $7 million. Hence, XYZ compant needs to chose wisely between the projects and spend only on those projects which add a positive value to the company.

Now, let is first understand what the term WACC, NPV, IRR and Payback period mean:

WACC: Weighted Average Cost of Capital is the average cost of funds (both debt and equity) for the company weighted in the same proportion.

NPV: NPV is calculated as the present value (PV) of all cash inflows less that present value of all cash outflows discounted at the cost of capital

IRR: Measures the rate of return of an investment

Payback Period: The time required to recover the initial capital spending on the project

XYZ company should only invest in those projects wherein the NPV is positive and IRR is greater than WACC because:

• Positive NPV of a project ensure that the money is not being lost considering the time value factor. The value of the future cash flows as on today's term (discounted) is greater than the capital outflow
• The IRR should be greater than WACC because it ensures that the project/capital is earning more return (IRR) than the cost of the capital (WACC).
• If in any case, the WACC > IRR then the NPV would also be negative. This is because, the return are lesser than the capital being invested and hence, the present value of the cash flows would be lower than the initial capital outflow.

The payback period of 3 years also ensures that the initial capital invested is returned in 3 years and the gestation period is small. XYZ company wouldn't have to wait for long before the initial capital is returned. Also, the payback period is sometimes linked to the indicative life of the devices being purchased (router & communication devices). If these devices have a life of 3-5 years then the payback period should get over before the indicative life of the device is over.