Capital Budgeting Case
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Capital Budgeting Case
QRB/501
November 25, 2013
In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages. The future cash flows of the project and discounts them into present value amounts using a discount rate that represents the project's cost of capital and its risk is whats needs to predict the investment. Next, all of the investment's future positive cash flows are reduced into one present value number. Subtracting this number from the initial cash outlay required for the investment provides the net present value (NPV) of the investment. Using the internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows (Investopedia, 2009). IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment (Investopedia, 2009). The catch is that discount rates usually change substantially over time. IRR does not account for changing discount rates, so it’s not adequate for longer-term projects (Investopedia, 2009).
The NPV method is inherently complex and requires assumptions at each stage - discount rate, likelihood of receiving the cash payment, etc. The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. The result is simple, but for any project that is long-term, that has multiple cash flows at different discount rates, or that has uncertain cash flows - in fact, for almost any project at all - simple IRR isn't good for much more than presentation value (Investopedia, 2009).
The net present value shows that Company B is worth more than Company A. After expenses, taxes and depreciation the company has a value that is more...
QRB/501
November 25, 2013
In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages. The future cash flows of the project and discounts them into present value amounts using a discount rate that represents the project's cost of capital and its risk is whats needs to predict the investment. Next, all of the investment's future positive cash flows are reduced into one present value number. Subtracting this number from the initial cash outlay required for the investment provides the net present value (NPV) of the investment. Using the internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows (Investopedia, 2009). IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment (Investopedia, 2009). The catch is that discount rates usually change substantially over time. IRR does not account for changing discount rates, so it’s not adequate for longer-term projects (Investopedia, 2009).
The NPV method is inherently complex and requires assumptions at each stage - discount rate, likelihood of receiving the cash payment, etc. The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. The result is simple, but for any project that is long-term, that has multiple cash flows at different discount rates, or that has uncertain cash flows - in fact, for almost any project at all - simple IRR isn't good for much more than presentation value (Investopedia, 2009).
The net present value shows that Company B is worth more than Company A. After expenses, taxes and depreciation the company has a value that is more...