Question

Find an article where one of the methods of capital budgeting (net present value, payback period, profitability index, etc ) is used by a company for a project and the result of the project. Based on the method used, did the company move forward with the project or dissolve the project? Your blog must be 300-500 words.

Answer 1

Example 1 – cash inflow project:

The management of Tata motors is considering the purchase of a new equipment to be attached to the main machine.

The cost of the equipment is $8000 and will increase cash flows by $3000.

The useful life of the equipment is 8 years. After 8 years it will have no salvage value. The management wants a 15% return on all investments.

Required:

1. Compute net present value (NPV) of this investment project.
2. Should the equipment be purchased according to NPV analysis?

Calculation of the NPV :

CFO = (8000)

CF1 TO CF8 = $3000

REQUIRED RETURN = 15%

The NPV IS $5461.96.

NPV can also be calculated as :

($8000) + 3000/1.15^1 + 3000/1.15%2 + ..... 3000/1.15^8

NPV is $5461.96

Purchase decision/result of the project:

Yes, the equipment should be purchased because the net present value is positive $5461.96. Having a positive net present value means the project promises a rate of return that is higher than the minimum rate of return required by management (15% in the above example). Positive NPV projects means that the investment in this project will generate revenues and will result in wealth generations, If the NPV is negative, it results in destruction of wealth of the investor.

The company has moved forward with the project.

The minimum required return is 15%, which means that if the company does not purchase this equipment and invest the money elsewhere then they should be earning 15% on it. The minimum required rate of return is also called the discount rate as it is used in discounting cash flows and finding the present value of the cash flows.

NPV is not only used for evaluating projects that generate an inflow, but also those projects that creates cost savings/reduce costs.

The advantage of net present value method is that it considers the" time value of money". The disadvantage is that it is more complex than other methods that do not consider present value of cash flows.