Capital Budgeting Analysis

Capital budgeting involves evaluating and selecting long-term investment projects based on their potential profitability. In this analysis, we will compute various financial metrics for different projects to determine their viability.

1. Project Y NPV Calculation and Decision

Given cash flows for Project Y:

Year Cash Flow
0 -$8,000
1 $3,350
2 $4,180
3 $1,520
4 $300

NPV Formula: NPV = Σ(CFt / (1 + r)^t) – Initial Investment

NPV Calculation: NPV = -8000 + 3350/(1+0.10)^1 + 4180/(1+0.10)^2 + 1520/(1+0.10)^3 + 300/(1+0.10)^4

Decision: If NPV > 0, accept the project; if NPV < 0, reject the project.

2. Project X Payback Period Calculation and Decision

Given cash flows for Project X:

Year Cash Flow
0 -$1,450
1 $250
2 $380
3 $620
4 $1,000
5 $100

Payback Period Formula: Payback Period = Number of years before cumulative cash inflows ≥ Initial Investment

Payback Period Calculation: Identify the year at which cumulative cash inflows equal or exceed the initial investment.

Decision: If the payback period is less than the maximum allowable payback period, accept the project; otherwise, reject it.

3. NPV and IRR for Mutually Exclusive Projects A and B

Given cash flows for Projects A and B:

Year Cash Flow A Cash Flow B
0 -$50,000 -$50,000
1 $15,625 $0
2 $15,625 $0
3 $15,625 $0
4 $15,625 $0
5 $15,625 $99,500

NPV Formula: NPV = Σ(CFt / (1 + r)^t) – Initial Investment

IRR Formula: IRR is the discount rate that makes NPV equal to zero.

Decision: Compare the NPV values for both projects to determine the most profitable option. Select the project with the higher NPV or IRR.

4. Los Angeles Lumber Company Project Analysis

Given inflows for LALC project:
Initial Cost: $1,000
Cash Inflows: $300 per year for years 1-5
Cost of Capital: 12%

IRR Calculation: Find the discount rate that makes the project’s NPV equal to zero.

NPV Calculation: Calculate NPV using the formula and compare it with zero to determine project viability.

5. Project with Expected Cash Inflows

Given project information:
Cost: $65,000
Cash Inflows: $12,000 per year for 9 years
Cost of Capital: 10%

IRR Calculation: Compute IRR to determine the project’s rate of return.

MIRR Calculation: Calculate MIRR to account for reinvestment rates and provide a more accurate representation of profitability.

6. Comparison of Capital Budgeting Methods

– NPV: Considers the absolute value of cash flows and provides a dollar amount of profitability.
– IRR: Focuses on the rate of return and is useful for comparing projects against a required rate of return.
– MIRR: Considers both the cost of capital and reinvestment rate, providing a more accurate picture of project profitability over time.

In conclusion, NPV is generally considered the superior capital budgeting method as it accounts for both the timing and magnitude of cash flows, making it a more reliable indicator of a project’s profitability. IRR can be a good supplementary metric for decision-making, while MIRR offers a better reflection of true project returns when compared to IRR.