Capital Budgeting Mini-Case There Are Term Paper

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For company B, the risks associated with cash flows are higher than that for company A, and are in the order of 11%, but nevertheless, the IRR on the cash flows is higher than the minimum required rate of return of 11% making this investment also attractive. As these two projects are mutually exclusive, and considering only IRR investment selection criteria, purchase of company B. with IRR of 14,305% is more profitable investment than purchase of company A with IRR of 13,052%. The IRR method does not consider the size of the initial investment necessary to achieve this rate of return on the cash flows and thus is not a perfect investment decision tool, as typically higher initial investment require much higher minimum rates of return to motivate investor sacrifice this capital and enter into the project.

The payback period reflects the number of years it takes for a specific cash flow from investment to amount to initial investment into this project. If the cash flows form the project are constant in the time, the payback period formula is simply the result or the ratio of initial investment or capital spent to annual cash flows. In the subject example, the cash flows are not constant in time, and the capital initially spent is subtracted from net annual cash flows to estimate the year in which the cash flows will break even. For company A, the payback period is 4 years, where already in the 4th year the company will achieve $28,174 above the initially spent amount. For company B, the payback period is also 4 years, and in the 4th year of operation the company will achieve $42,236 above the initially spent amount. Considering the fact that both company A and B. require the same initial investment, company B. is more profitable and has better payback period.

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The payback period investment selection criteria is flawed by the fact that it does not consider cash flows after the cut off period, which can be much higher than for an investment project with lower payback period, but not as profitable in the longer term. Also, payback period does not consider time value of money and thus the risks associated with achieving the cash flows for different projects, and thus can favor short-term riskier projects over more long-term but sustainable project. On the other hand, payback period is good investment selection criteria for the companies that have tight capital requirements and need to recover their initial capital outlay rather fast.

Profitability index considers the time value of cash flows to be achieved from the project and the size of the initial investment, it shows the NPV per 1$ invested into the project. For company A, the NPV of cash inflows divided by initial investment is $1,084, while it is higher and is $1,086 for the company B.

As mentioned above on the flaws with payback period method, discounted payback period method accounts for time value of money and is a better investment tool. For company A, the discounted payback period is 5 years, and is also 5 years for company B, while is the net amount in present value left to the company after recovering initial outlay, is higher for company B.

Modified Internal rate of return is an investment tool used for valuing investment projects with complicated cash flows. Namely, it is applied when the cash flows "change their sign" more than once. To calculate the MIRR, it is necessary to know the company finance rate, which is not applicable in this situation and thus makes it impossible.

Based on all the investment tools applied, company B. is a.....

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