NPV= 68,009,000
The company should accept the project as the NPV gives a value less high than zero. The implication is that the project’s cash inflows will repay its cash outlay within six years of operation.
REGULAR PAY BACK PERIOD
The project will not have paid back the initial capital outlay. A viable project should take the shortest time period to repay back the initial capital outlay (Röhrich, 2007). In this case, the project will have not paid $106, 000,000 by the end of year three, and so should be rejected.
USING DICOUNTED PAY BACK PERIOD
INTERNAL RATE OF RETURN
IRR is the rate of return that equates or gives a zero Net Present Value. IRR is calculated using a trial and error approach where two NPV’s are used in determining the rate that equates the MNP to zero. The steps involved in this method include; calculation of the NPV at with the company’s rate. Find a rate that gives an NPV with an opposite sign as with the provided rate. A point to note using this approach is that NPV and the rate of return are inversely related so that when the rate increases, NPV decreases (Götze, Northcott, and Schuster, 2008). The opposite is also true. With the two NPV’s (one positive and the other one negative) the implication is that NPV=0 lies between the two. With these two NPV, the rate at which NPV is zero is then calculated by the following formula;
IRR= Lower rate + {[NPV Lower rate/NPV absolute] * difference of the rates}
OR, IRR= a + {[NPV a/(NPVa - NPVb)] * (b-a)} ,,
Where, a; lower rate
b; Upper rate.
NPVa; NPV using lower rate (positive value)
NPVb; NPV using higher rate (Negative value)
The decision criteria using IRR is that if IRR is higher than the rate the project should be rejected. If lower than the cost of capital (rate) the project should be accepted, and if equal to the cost of capital the decision is indifferent, and remains on the management’s policies.
Calculations of IRR.
At r=12.5%, NPV= 68,009,000, therefore, consider a lower cost of capital than 12.5%
At r=30%, NPV= (27,990,500)
Using the IRR Formula above;
IRR= 12.5 + {[68009,000 /(6,8009,000+27,990,500)] * (30-12.5)} = 24.75%o The management’s rate is lower than IRR, so the project should be accepted.
MODIFIED RATE OF RETURN (MIRR)
This is an improvised version of IRR where instead of using the assumption that the project’s cash flows are reinvented at the IRR, it factors a detached re-investment rate into the model (Dayananda, 2002). The formula used is;
MIRR= n √Sum of Terminal Cash Flows/Initial Investment – 1
Using a discrete rate of 10%,
MIRR= 6√381,411,400/125,000,000 – 1=20.4%
The MIRR (20.4%) is higher than 12.5%, therefore this project should be accepted.
Advantages and disadvantages.
The purpose of the report on capital budgeting method lies is to provide the alternatives in making decisions on mutually existing projects, useful in expansion and acquisition of portfolio, when replacing or changing existing technologies, while developing new product lines, and in research and development programs (Baker, and English, 2011). The different methodologies apply to determine the best projects that meet the business objective.
REFERENCE.
Baker, H. K., & English, P. (2011). Capital budgeting valuation: Financial analysis for today's investment projects. Hoboken, N.J: Wiley.
Dayananda, D. (2002). Capital budgeting: Financial appraisal of investment projects. Cambridge: Cambridge University Press.
Götze, U., Northcott, D., & Schuster, P. (2008). Investment appraisal: Methods and models. Berlin: Springer.
Röhrich, M. (2007). Fundamentals of investment appraisal: An illustration based on a case study. München [u.a.: Oldenbourg.
