capital budgeting case

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university of phoenix material

capital budgeting case

your company is thinking about acquiring another corporation. you have two choices—the cost of each choice is $250,000. you cannot spend more than that, so acquiring both corporations is not an option. the following are your critical data:

corporation a

revenues = $100,000 in year one, increasing by 10% each year
expenses = $20,000 in year one, increasing by 15% each year
depreciation expense = $5,000 each year
tax rate = 25%
discount rate = 10%

corporation b

revenues = $150,000 in year one, increasing by 8% each year
expenses = $60,000 in year one, increasing by 10% each year
depreciation expense = $10,000 each year
tax rate = 25%
discount rate = 11%

compute and analyze items (a) through (d) using a microsoft® excel® spreadsheet. make sure all calculations can be seen in the background of the applicable spreadsheet cells. in other words, leave an audit trail so others can see how you arrived at your calculations and analysis. items (a) through (d) should be submitted in microsoft® excel®; indicate your recommendation (e) in the microsoft® excel® spreadsheet; the paper stated in item (f) should be submitted consistent with apa guidelines.

a. a 5-year projected income statement
b. a 5-year projected cash flow
c. net present value (npv)
d. internal rate of return (irr)
e. based on items (a) through (d), which company would you recommend acquiring?
f. write a paper of no more 1,050 words that defines, analyzes, and interprets the answers to items (c) and (d). present the rationale behind each item and why it supports your decision stated in item (e). also, attempt to describe the relationship between npv and irr. (hint. the key factor is the discount rate used.) in addition to the paper, a micosoft® excel® spreadsheet showing your projections and calculations must be shown and attached.

capital budgeting – clarification example

when people hear the term capital budgeting, they usually focus on the budgeting part of the term rather than the capital portion. actually, capital is the more important aspect because it shows you that you are evaluating a larger expenditure that will be capitalized—in other words, depreciated over time. remember, a capital expenditure can be many things—a large copying machine, an automated assembly line, a building, or the ultimate in capital budgeting—the acquisition of another entity. what is important about capital budgeting is it allows you to analyze one or more projects so you can intelligently and strategically decide on which project you wish to acquire or which piece of equipment you should procure.

there are at least six capital budgeting tools you can use in analyzing a capital expenditure: net present value (npv), internal rate of return (irr), profitability index (pi), payback period (pb), discounted payback period (dpb), and modified internal rate of return (mirr), although the textbook mainly focuses on net npv and irr. in a prior finance course, you might have learned how to calculate four of the six tools—npv, irr, pi, and pb. if not, then this will be new material for you.

crunching the numbers might seem by some to be the more crucial part—and it is indeed important. however, interpreting and analyzing the answers are just as important. see if you can do this with the six capital budgeting tool answers that you will be computing in the following example.


suppose you are thinking of acquiring either the abc or the xyz company. both have a purchase price of $500k so you cannot readily see which choice would be in your best interest. you also have a capital restraint of approximately $500k so you cannot purchase both entities. thus, you provide your accountants and analysts with the historical financial details of both companies. they spend a few days forecasting 5 years of detailed financial statements based on how your company would operate these two corporations. the following are the results that ended with the projected 5-year net cash flow figures. year 0 shows the initial cost outlay (or purchase price), and years 1 through 5 show the projected cash inflow if you make the purchase.

0 1 2 3 4 5

abc -500 100 200 575 325 100

xyz -500 275 250 75 250 450

it is an interesting coincidence to note that if you total both rows for each company, they are the same. however, you know that this does not matter in that comparing totals ignores the time value of money and is not a valid capital budgeting tool in making strategic decisions for your firm.
let’s first look at two of the more popular capital budgeting tools, npv and irr. as you are doing, you always look at the projected cash flows for each project—not net income. to compare the projects on equal terms, you bring back the future cash flows to the present, which is the present value concept. then, you subtract the cost of that project from its present value—thus, npv.
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