Capital Budgeting.
AThe Net Present Value is the present worth of the future expected cash flows. The following is a table showing the calculations of the Net Present Value.
| Year(t) | Cash flow(Rt) | Discount rate %(i) | NPV=Rt/(1+i)t | NPV |
| 0 | -400000 | 0 | -400000/(1+0)0 | -400000 |
| 1 | 100000 | 2 | 100000/(1+0.02)1 | 98039.22 |
| 2 | 120000 | 6 | 120000/(1+0.06)2 | 106799.57 |
| 3 | 850000 | 11 | 850000/(1+0.11)3 | 621512.67 |
The project’s modified internal rate of return is calculated as follows. MIRR is calculated as follows:
We assume 10% finance rate and 12% reinvestment rate.
Present value (PV) of the negative cash flows= -400000/(1+0.10)0 = -400000
Future Value (FV) of the positive cash flows= ﴾100000 × (1+0.12)1﴿ +﴾120000 × (1+0.12)2﴿ + 850000 = 1112528
MIRR=3√1112528/400000 – 1= 66.8%
The discount rate at which the graph intersects the horizontal axis is 1.8%.
Initially when the project starts the discount rates for the money invested increases with the increase in the net cash flow. The increase in the net cash flow increases at a rate lower to that of the increase in the discount rate just after the breakeven point is passed. Slightly above the break even point the cash flows are interest rates inelastic. After the interest rate is at 3% the cash flows starts increasing at the same rate with the increase in the discount rate.
B
| Year(t) | Cash flow(Rt) | Discount rate %(i) | NPV=Rt/(1+i)t | NPV |
| 0 | -815000 | 1 | -815000/(1+0.01)0 | -815000 |
| 1 | 141000 | 4 | 141000(1+0.04)1 | 135576.92 |
| 2 | 320000 | 10 | 320000(1+0.10)2 | 264462.81 |
| 3 | 440000 | 18 | 440000(1+0.18)3 | 267797.58 |
The Internal Rate of Return (IRR) = -815000/ (1+r)0 + 141000/(1+r)1 + 320000/(1+r)2+ 440000(1+r)3 = 0 r =1.3
On the graph the curve cuts the x-axis at a point 1.3%
The graph starts at a point where the outflows are grater than the inflows by 815000. The internal rate of return is at 1.3%. As the rate of interest increases the net cash flow also increases. Passed the 1.5% discount rate the cash flow increase gradually.
CNPV/Initial Investment= Profitability Index.
The Net Present Value=Profitability Index*Initial investment.
= 0.94*4.2=3.94
Part 2.
The net present value is the better method to use in comparison to internal rate of return. The net present value shows the list of all the future expected inflows of cash from an investment. This helps the project planners to know the value of the project. Net present value takes into account the time value of money. This help to take into account the cost of inflation which could either lower the value of the money or increase it. Net present value of money discounts future incomes to know their present worth.
The net present value is used in evaluating different project which are mutually exclusive and knowing the most profitable project. Net present value is used to rank closely related projects in the order of their profitability thus knowing which projects to implement first depending on the net value of the projects. (Bichler, 2009)Net present value is appropriate in the projects evaluation since it portrays whether a project would add value to the business or would deduct value from the business.
If the net present value obtained after discounting the future incomes, is positive then the project would add value to the business and if negative it would deduct value from the business. Therefore net present value is appropriate since it helps to know whether to accept the project or reject it on the basis of value addition to the business. The business will accept projects that add value to it and reject projects that deduct value from the business. Upon acceptance of the project the project that will add the greatest value to the business is the one that is implemented first followed by the second project to add the second largest value to the business. (Baker, 2007)
Net present value is the most suitable method in the evaluation of projects because it gives an advice on making decisions concerning which projects are better than others. This is made possible through ranking the projects on the basis of the net present value. The project with the largest positive net present value is ranked first followed by the subsequent projects systematically. The net present value is also appropriate since it takes into consideration the risks associated with future cash flows. Net present value is appropriate since it gives an absolute value of a given project. Thus able to determine the appropriate project in the evaluation of the projects. (Shapiro, 2005)
REFERENCE
Dayananda, D. & Irons, R. (2002). Capital budgeting: financial appraisalof investment projects. Waterfront, Cape town, South Africa.
Pamela, P., P. & Trank, J., F. (2002). Theory and practice. John Wiley & Sons Inc, Canada
Part 2.
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