Capital Budgeting
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Strident Marks can utilize the capital budgeting to evaluate their proposed long-term investments. Once we have identified a list of potential investment projects, the next step in the process will be to estimate the expected cash flows and risk of each project. Based on these estimates, we can evaluate each project and decide which set of projects are the best for Strident Marks to undertake. The primary decision methods used to evaluate the projects will be payback, net present value, and internal rate of return(Gallagher, 2003).
The simplest capital budgeting method is the payback method. The analyst must calculate the number of years it will take to recoup the projects initial investment (Gallagher, 2003). This is done by adding up the projects cash inflows one year at a time until the sum equals the amount of the projects initial investment. The number of years is the payback period. To evaluate this method, the manager must have in mind a particular number of years that is acceptable to the firm. If the payback period is less than or equal to that predetermined number, then the project is accepted.
Payback Method for Strident Marks Project
Period
Initial Investment
-$10,000
Cash Flow
$7,500
Remaining
-$2,500
Cash Flow
$7,500
Remaining
$5,000
Cash Flow
$7,500
Remaining
$12,500
Solution:
Payback (in years) =
1 + (5,000/7,500)
Payback =
years
The decision rule for payback method depends on managements acceptable payback period. If the proposed projects payback exceeds the acceptable time limit, then the project is accepted. Otherwise, the project is rejected.
The problem with the payback method is that this method does not consider cash flows that occur after the payback period, nor does it consider time value of money (Gallagher, 2003).
The second method that Strident Marks can utilize to analyze the worth of its impending project is to use the net present value (NPV). NPV of Strident Marks proposed project is equal to the present value of the cash inflows minus the present value of the cash. The equation to calculate NPV is as follows:
where CFt is the cash flow at time t, k is the appropriate discount rate. Our project can be acceptable if the NPV is greater than or equal to zero and unacceptable otherwise. An NPV profile that shows the NPV for various discount rates will show how sensitive the projects NPV is to the discount rate assumption. Taking into account our Projects key financial data, we can compute the NPV as follows: