Capital Budgeting Measurement Criteria
Introduction
In this assignment, you will learn about the capital budgeting process, which is basically how companies evaluate their investment in various projects, such as buying new machinery or expanding into a new plant. In addition, you will learn about the following techniques used in capital budgeting:
- Net Present Value.
- Internal Rate of Return.
- Modified Internal Rate of Return.
- Payback Period.
- Discounted Payback Period.
- Profitability Index.
Instructions
Answer the following questions and complete the following problems, as applicable.
You may solve the following problems algebraically, or you may use a financial calculator or Excel spreadsheet. If you choose to solve the problems algebraically, be sure to show your computations. If you use a financial calculator, show your input values. If you use an Excel spreadsheet, show your input values and formulas.
Note: In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer.
- Question 1:
- Proficient-level: Describe the Net Present Value (NPV) method for determining a capital budgeting project's desirability. What is the acceptance benchmark when using NPV?
- Distinguished-level: Identify the NPV method's strengths and weaknesses.
- Question 2:
- Proficient-level: What is the payback period statistic? What is the acceptance benchmark when using the payback period statistic?
- Distinguished-level: Identify what problem of the Payback Period method is corrected by using the Discounted Payback Period method.
- Question 3:
- Proficient-level: Describe the Internal Rate of Return (IRR) method for determining a capital budgeting project's desirability. What is the acceptance benchmark when using IRR?
- Distinguished-level: Explain how the NPV and IRR methods are similar and how they are different.
- Question 4:
- Proficient-level: Describe the Modified Internal Rate of Return (MIRR) method for determining a capital budgeting project's desirability. What are MIRR's strengths and weaknesses?
- Distinguished-level: Explain the differences in the reinvestment rate assumption that distinguishes MIRR from IRR.
- Question 5:
- Proficient-level: Compute the NPV statistic for Project Y and tell [advise] whether the firm should accept or reject the project with the cash flows shown in the chart if the appropriate cost of capital is 12 percent.
- Distinguished-level: Explain how decreases in the cost of capital lead to an increase in the number of approved projects.
Project Y
| Cash Flow |
-$8,000 |
$3,350 |
$4,180 |
$1,520 |
$300 |
(Cornett, Adair, & Nofsinger, 2016, p. 332).
- Question 6:
- Proficient-level: Compute the payback period statistic for Project A and recommend whether the firm should accept or reject the project with the cash flows shown in the chart if the maximum allowable payback is four years.
- Distinguished-level: If the discounted payback period were computed, identify if it would be less than, equal to, or greater than the non-discounted payback period.
Project A
| Cash Flow |
-$1,000 |
$350 |
$480 |
$520 |
$300 |
$100 |
(Cornett, Adair, & Nofsinger, 2016).
Submit your completed assignment as an attachment in the assignment area. You may use either a Word document or an Excel spreadsheet for your work, but not both. Prior to submitting your assignment, review the Estimating Risk and Return Scoring Guide to ensure you have met all of the requirements and as a self-assessment of your work.
Reference
Cornett, M. M., Adair, T. A., & Nofsinger J. (2016). M: Finance (3rd ed.). New York, NY: McGraw-Hill.
PART 2
Measuring Capital Budget Desirability
Review the Discussion Participation Scoring Guide.
Chapter 13 in the M: Finance textbook by Cornett, Adair, and Nofsinger discusses various criteria for calculating and analyzing the desirability of a capital budgeting project. This task is extremely important as these projects often entail very large cash outflows and may significantly determine the future profitability of the firm. Examine Chapter 13, with particular emphasis on each of the six capital budgeting techniques reviewed.
For this discussion post, assume the role of chief financial executive of a firm that is analyzing a major project that entails a large initial cash outflow at time point zero and has future expected cash inflows occurring over the next 10-year period.
- If you could select only three techniques to analyze this project's desirability, which three techniques would you select? Why?
- When analyzing a project's desirability, which factor do you believe is more important: the technique to analyze investment acceptability, or the use of the most accurate projections of cash flows? Why?