Assignment 3: Crunching the Numbers
1. Use Excel, or another suitable program, to calculate Payback Period for Option A, Internal Rate of Return for Option A, Net Present Value for Option A, Payback Period for Option B, Internal Rate of Return for Option B, Net Present Value for Option B
Capital Budgeting techniques allow organizations to evaluate their long-term investments and to determine whether they are worth pursuing. The most common capital budgeting tools are the payback period, Net Present Value (NPV) and Internal Rate of return (IRR) (Hansen, Mowen & Guan, 2009).
Payback period refers to the time necessary to recover the money invested in the project. It is calculated as a ratio of the cost of project to the annual cash inflows. This method considers only the nominal monetary value, while it fails to take into account the time-value of money and the opportunity cost (Payback period).
Net Present Value (NPV) considers the timing of investments by calculating the difference between the values of cash inflows and outflows taken at their present value. It is calculated using the following formula NPV = Σ (Ct / (1 + r)t) – C0, where C0 is the initial cost of starting a project, Ct represents the net cash flows and r indicated the discount rate (Brigham & Houston, 2009).
Internal Rate of Return (IRR) is the discount rate, which is required to make NPV of a project equal to zero. The higher the IRR, the more desirable a project is. However, IRR should also exceed the cost of capital in order to be considered for investment (Baker, 2000).
Based on the Payback Period method, the investment for the Option B will be recovered during year 6. NPV of the project is negative, therefore indicating that Option B is not a good investment opportunity. However, IRR of the Option B is higher than the one of Option A and exceeds the cost of capital of 12%, therefore the project should be accepted.
2. Using the calculations in the first criterion, clearly present the results for Option A and for Option B as though for an audience of city council members.
According to the calculations presented in Table 1 and Table 2 above, it will take approximately 9 years to recover the investment for Option A , while only 6 for Option B. The NPV for both projects is highly negative, therefore indicating that none of the options should be pursued by the city council, however, the value of IRR indicates the preference for Option B, since IRR for Option B exceeds the one for option A and the cost of capital, 12%.
3. The city council says they can adopt only one (1) of the projects this year. Pick one (1) and justify the choice to the city council.
If the city council can only adopt one of the projects, it should definitely select Option B. This conclusion can be derived by the shorted payback period for Option B, as well as by the higher level of IRR, which exceeds the cost of capital. Option A, on the other hand, should not be undertaken due to a small IRR value, negative NPV and a long payback period.
4. You are getting pushback from the city engineer that both projects are vital and should be done this year. You really want to find a way to make both projects happen. Create a solution that would allow both projects to be implemented.
According to the previously presented calculations, only Option B can be undertaken based on the IRR method. Both NPV and payback indicate that neither of the two projects should be followed. However, if the city engineer insists on the completion of both projects, it is necessary to make some adjustments. One option would be to attempts to reduce project costs, both in terms of the cost of capital and in terms of the operating and maintenance cost. However, if this is not an option and no further cost reduction is possible, it is important to find other ways to improve NPV and IRR of the projects. Thus, city council may negotiate more favorable conditions with suppliers of the capital and spread the payment of the cost of capital over several years. In this case, due to the time-value of money concept both the NPV and IRR of the two options will improve. Another alternative would be to start these projects non-simultaneously, thus limiting their dependence on each other and reducing the cash needed for funding those projects at one point of time. Additional funds can be also borrowed from external sources, in order to cover the lack of financial resources and to undertake both Options.
References
Baker, S. L. (2000). Perils of the internal rate of return. Retrieved from
http://hspm.sph.sc.edu/courses/econ/invest/invest.html
Brigham, E., & Houston, J. F. (2009). Fundamentals of financial management. (12 ed.). Mason,
OH: South-Western Cenage Learning.
Hansen, D. R., Mowen, M. M., & Guan, L. (2009). Cost management: accounting & control.
(6th ed.). Mason, OH: South-Western Cengage Learning.
Payback period. In Investopedia Retrieved from
http://www.investopedia.com/terms/p/paybackperiod.asp
