Capital Budgeting

Introduction

Our company is in a pivotal period of growth, and we are evaluating three mutually exclusive capital projects to determine the most strategic allocation of our resources. These projects, designated as Project A, Project B, and Project C, have been proposed to enhance our operational capabilities and market position. To make an informed, data-driven decision, this report will apply the fundamental principles of capital budgeting.

We will use the following capital budgeting tools to assess each project's financial quality:

Net Present Value (NPV): This is the gold standard of investment evaluation, measuring the difference between the present value of future cash inflows and the initial investment. A positive NPV indicates that a project is expected to add value to the company.

Internal Rate of Return (IRR): The IRR is the discount rate at which the NPV of a project's cash flows equals zero. A project is deemed acceptable if its IRR exceeds the company's cost of capital.

Payback Period: This metric calculates the time required to recover the initial investment. While it does not consider the time value of money or cash flows after the payback date, it is a useful measure of a project's liquidity and risk.

For this analysis, we will use a cost of capital of 10%, which represents the company's weighted average cost of capital (WACC) and the minimum acceptable rate of return for any new project.

2. Project A: Product Line Expansion

Project Description

Project A involves the expansion of an existing product line to capture a larger market share. This expansion requires an initial investment in new manufacturing equipment and a marketing campaign. The project is expected to have a useful life of five years.

Financial Data and Computations

Initial Investment (

• C0​

): -$10,000,000

Annual Cash Flows:

Year 1: $3,000,000

Year 2: $3,500,000

Year 3: $4,000,000

Year 4: $4,500,000

Year 5: $5,000,000

Net Present Value (NPV)

The NPV is calculated by discounting each cash flow to its present value and subtracting the initial investment.

NPV=t=1∑5​(1+r)tCt​​−C0​

Year 1 PV:

• 3,000,000/(1.10)1=2,727,273

* Year 2 PV:

• 3,500,000/(1.10)2=2,892,562

* Year 3 PV:

• 4,000,000/(1.10)3=3,005,263

* Year 4 PV:

• 4,500,000/(1.10)4=3,071,607

* Year 5 PV:

• 5,000,000/(1.10)5=3,104,607

Sum of Present Values =

2,727,273+2,892,562+3,005,263+3,071,607+3,104,607=14,801,312NPV=14,801,312−10,000,000=$4,801,312

Internal Rate of Return (IRR)

Using a financial calculator or spreadsheet software, the IRR for Project A is calculated to be 24.16%. Since 24.16% > 10% (the cost of capital), the project is considered financially acceptable.

Sample Answer

Executive Summary

This report provides a comprehensive capital budgeting analysis of three potential investment projects: Project A (Product Line Expansion), Project B (Technology Infrastructure Upgrade), and Project C (New Distribution Center). Using key financial tools, including Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period, the projects were evaluated based on a 10% cost of capital. The analysis reveals that all three projects are financially acceptable as they have positive NPVs and IRRs greater than the cost of capital. However, Project B stands out as the superior choice. Its NPV of $2,580,210 is the highest among the three, indicating it will generate the most absolute wealth for the company. This recommendation is made despite Project C having a faster payback period, as NPV is the most reliable metric for maximizing shareholder value. We recommend moving forward with Project B to bring the most value to the compan