Capital Budgeting
Anne E. Sobala
Western Governor’s University
September 11, 2012
Qn 1. Cash Flow and Depreciation
• Net Cash Flow = Net Income + Depreciation + Amortization
(Brigham & Ehrhardt, 2010)
• Taxable Income is overstated and Net Income is reduced due
to this effect.
• Further reduction in Net Cash Flow will occur because,
normally, depreciation is added back in the calculation of Net
Cash Flow.
• Therefore, the value of Net Cash flow appears lower if not
corrected for inflation.
• For Year 2, it will be less by $398,750 ( the value of
depreciation) and the additional impact of tax.
• The value would be $624688-$398750=$225,938
Qn. 2. Net Present Value Analysis
• Investment projects that have a positive net present value are
viable in economic terms (Booker, 2006)
• The Net Present Value of the investment project is positive i.e.
$346,250.
• This means that by the end of the 8th year, the investment will
have generated a positive value of $346,250.
• Based on this consideration, it is recommendable that the
project should be implemented.
• A positive value of NPV adds to capital with time and corrects
for depreciation.
• Projects with negative values of NPV should not be
implemented.
Qn.3. Internal Rate of Return
• IRR is a preferred viability assessment value for investments.
• Reason: It measures the effective interest rate of an investment
i.e. interest earned on capital.
• An investment project with a positive NPV has its IRR higher
than the weighted average cost of capital (in this case 12%).
• The IRR for the project is 12.9%
• IRR is a more preferred evaluator of investment options.
• Recommendation: The is a viable because its IRR is higher
than WACC.
Qn 4. Accounting Rate of Return Vs Internal
Rate of Return
• IRR for the project is 12.9% while the AAR is 22.1 %
• AAR is higher because IRR does not take into account the net
percentage of profit, while ARR does.
• IRR is adjusted for time while ARR is not sensitive to the time
value of money.
• IRR, therefore, gives a more predictive evaluation of
prospective investment.
• IRR is based on current values of cash inflows while ARR is
based on profits.
Qn. 5.Payback Period
• Payback period is important in determining whether capital
investment will be recovered within the lifespan of the project
• In this case, the payback period is 4 years and 9 months.
• This period is less than the 8 years which is the project’s life
span.
• Recommendation: Project should be implemented because it
will pay back investment within the project period.
• Unadjusted Payback time, does not take into account time
value of money hence may not provide a good judgment of the
project’s potential
• It also does not give an idea of the cash flows after the
payback period of the investment.
Qn. 6. Weighted Average Cost of Capital
(WACC) and NPV
• WACC is a measure of the cost of each unit of money relative
to time.
• WACC assumed for this project is 12%
• NPV adjusts cash flows for the time value of money
• Therefore, Weighted Average Cost of Capital measures the
value of a project relative to WACC.
Qn. 7. WACC and IRR
• In assessing the viability of the project a comparison of IRR
and WACC is done.
• If WACC is higher than IRR then the investment project
should not be implemented
• This is because the project would not be adding value to its
capital. It will be depreciating in value
• Projects are viable only if they show a positive NPV and a
value of IRR higher than the average cost of capital
References
• Booker, J. (2006). “Financial Planning Management”. Ontario:
CCH
• Brigham, E. F. & Erhardt, M. C. (2010). Financial
Management: Theory and Practice”. Mason, OH:
Cengage Learning
• Crundwell, F. K. (2008).”Finance for Engineers: Evaluating
and Funding of Capital Projects”. London: SpringerVerlag
• Loughran, M. (2011). “Financial Accounting for Dummies”.
Indianapolis: Wiley Publishers, Inc.
• Plewa, F. J. & Friedlob, J. T. (1995). “Understanding Cash
Flow”. New York: Wiley