Solution: Company XYZ Ltd provides the following detail regarding their project for 10 years.

If projects are mutually exclusive, not so well. NPV is used by almost all firms as a key capital budgeting decision tool.NPV profile is a graph that shows the relationship between a project’s NPV and the required return on the project. When the actual cost of capital is lower than the crossover rate, Project A should be taken because it has a higher NPV; when the actual cost of capital exceeds the crossover rate and as long as the NPV is positive, Project B should be accepted.To find the crossover rate, I first need to compute the incremental cash flows as the difference in the two projects cash flows (see the last column of the table above), and then calculate the IRR based on the incremental cash flows.While the data is starting to get dated, the most recent survey of capital budgeting techniques used in practice was conducted in 1999 and published in 2002 (Ryan and Ryan, 2002). It also considers all relevant cash flows.
It is also more insightful in … If initial investment sizes are very close, we likely will not encounter a size problem. However, if we are going to focus on maximizing shareholder wealth, then we want to rank projects based on how they add value to the firm. Capital budgeting projects can be thought of as independent projects (where we want to accept all good projects) or mutually exclusive projects (where we can only take one from the set so must choose the best project). It involves the following six steps:The organization’s all capital budgeting decisions can be broadly categorized under the following three types:Capital budgeting is a complicated and tedious process. While there are many different techniques for evaluating capital budgeting projects, the three most common are Payback Period, Internal Rate of Return, and Net Present Value. The NPV directly addresses the time value of money. To draw the NPV profile, we first need the project’s NPV at a number of different discount rates. Does this mean corporations are stupid? Explain.Calculate the PP, NPV, and IRR of the following projects (assuming a 14% required return and critical acceptance level of 3 years)Which project(s) should we accept if they are independent? For instance, we may project a 6-year life span for the project and find out after two years that the technology behind it has become obsolete and the project must end prematurely. Project A and Project B require the same initial investment at time 0, but their cash flows in the following years differ.The figure below shows two NPV profiles – one for A and one for B – and the following are worth noting:When the discount rate increases, the NPVs from both projects decline.Each project has only one fixed IRR. Following are some of the significant factors affecting investment decisions:What is the need for capital budgeting? For example, generating ideas is part of the process.A capital budgeting technique refers to the way we evaluate whether or not the capital budgeting project being evaluated should be accepted or not. McBurger could choose to take the new deep fryer or the new order placement, or it could choose both. To quote Prof. Myint, “the capital intensive or labour intensive methods of producing a particular commodity are classified by the modern factory methods of producing consumer goods and mechanized methods of constructing roads, irrigation works …

For example, the decision rule should consider all relevant cash flows is a criteria.A capital budgeting process is the set of procedures we want to follow throughout the analysis of a potential capital budgeting process. Here is a quick review for each calculator:Should we accept the project? While we will focus only on a small portion of the process (making the decision), it is worthwhile to look at the process as a whole.The process starts by generating potential ideas for capital budgeting projects. Next, identify a pair of projects that could suffer from the reinvestment rate problem, but not the size problem.Ryan, P. A., & Ryan, G. P. (2002). Second, if the timing of cash flows is vastly different (one project has cash flows come in evenly throughout the payback period and the other generates low cash flows early on and high cash flows near the end – or other such differences). Can we afford to undertake such an investment if we are having financial problems? However when projects are mutually exclusive, it will not always rank the projects correctly (again, see below). In 2 nd example, we will take the example of WACC (weighted average cost of capital) for calculating the NPV, because in WACC we consider the weight of equity and debt also the cost of equity and debt. Poor capital budgeting decisions can destroy wealth almost as quickly (especially if the firm does not recognize failure quickly enough and continues to throw good money after bad). Also, the decision rule is arbitrary – what is an acceptable payback period? Let’s stick with the example above, which requires an initial investment of $2,000 and generates $900 per year for the next three years. Here we must estimate how much it will cost us to initially purchase and implement new equipment, the life span of the project, the marginal revenue it will generate each year, the marginal costs associated with the project each year, etc. Very poorly. However, only NPV (which is used most frequently) meets all four of the criteria we designate as critical in choosing projects. If we don’t adequately address risk in the capital budgeting process, we will find firms over investing in high risk projects and under investing in low risk projects.This is something to be careful about. For mutually exclusive projects, accept the project with the highest positive NPV.Let’s consider the printing press example above, what is its NPV (assume the required return on the project is 10%, just like when we did the IRR analysis)?How well does the NPV meet our 4 criteria? We also should note that it is important to be careful about evaluating relevant cash flows. A capital budgeting technique refers to the way we evaluate whether or not the capital budgeting project being evaluated should be accepted or not.


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