Capital Budgeting DataCapital investments are animportant aspect of a company’s growth initiative. Capital budgeting provides management a wayto ensure the project and investment opportunities which best suit thecompany’s needs are pursued while rejecting those not meeting the criteria. It is a step by step process which createsaccountability and measurability for the project or investment beingconsidered.
Management can rank theprojects or investments resulting in the highest return on the invested fundsbeing the optimal choice. There areseveral methods management uses for capital budgeting; throughput analysis, netpresent value, internal rate of return, discounted cash flow or paybackperiod. Management must also considerwhether those projects under consideration are independent or mutuallyexclusive. Independent projects and investmentsare those whose cash flows are not affected by the acceptance or rejection ofother projects or investments. Whereasmutually exclusive projects are a group of projects or investments underconsideration for which at most only one would be accepted.Consideration for PotentialInvestment NPV CalculationNet Present Value allows formanagement to estimate the profitability of a project or investment. Co is representative of theinitial investment, shown as a negative cash flow as the funds are outgoing. A positive NPV indicates the projectedearnings exceed the anticipated costs.
In the case of Home Depot, theNPV of the project being considered is $9,785,570.71. Consideration for PotentialInvestment IRR CalculationThe internal rate of returnalso measures the profitability of an investment or project. In general, the higher the rate of return themore desirable the investment or project is.
The formula for which is0 = P0 + P1/(1+IRR) +P2/(1+IRR)2 + P3/(1+IRR)3 +P4/(1+IRR)4+P5/(1+IRR)5In this, Po,P1…P5 equals the cash flows in periods one through fiverespectively; while IRR represents the internal rate of return. For Home Depot’s project underconsideration, the IRR is 50%.Implications of thecalculationsThe NPVof Home Depot’s project is $9,785,570.71. NPV represents the difference between the present value of cash inflowsand the present value of cash outflows. Therefore, a positive NPV would indicate the projected earnings of aproject or investment exceeds the anticipated costs. Conversely, a negative NPV would indicate anet loss.
Calculations for the HomeDepot project under consideration denote a positive NPV thereby indicating theproject is acceptable.The Internal Rate of Return(IRR) also utilizes the net present value. However, the NPV is set to zero with the formula solving for thediscount rate or IRR.
Theoretically,projects or investments with an IRR greater than its weighted average cost ofcapital (WACC) would be a profitable one of which the company shouldundertake. IRR calculation for HomeDepot’s project is 50%. Therefore, thecompany should accept this project.Difference between NPV and IRRBoth the NPV and IRR measureprofitability often with similar results. However, there are projects and investments for which using onecomputation rather than the other will provide a more accurate calculation.An advantage of using NPV isthat it is an absolute measure. It representsthe value of money gained or lost by undertaking a particular project orinvestment.
NPV can also be used whenevaluating projects or investments when changes in cash flow are expected. Changes in discount rates will also producediffering results for the same project.IRR is representative of theyield a particular project or investment will provide. Since the IRR utilizes WACC it is arelatively easy measure to calculate and provides a way to compare the worth ofprojects or investments under consideration regardless of the size of theprojects. Unlike IRR, NPV lacks theability to compare projects of differing sizes.
NPV can indicate which projects shouldprovide a return on investment but cannot indicate which projects would providethe best return. Although IRR considersprojects of varying sizes, it cannot incorporate any changes in cash flow andprovides the same results even if the discount rate alters. Based upon the variousadvantages and disadvantages of both NPV and IRR, NPV would be the suggestedmethod of measurement for the project under consideration by Home Depot.
This method provides a more accuratemeasurement of the expected return on investment. With this said, the NPV indicates a positive figurewhich correlates into an acceptable project for Home Depot to pursue.