Capital Budgeting Process

Today we will be looking at the key financial metrics of the capital budgeting process for an analysis of a possible investment for Strident Marks. I have calculated the payback period, the net present value, and the internal rate of return. Each of these is important to Strident Marks so we can make proper decisions about this possible investment. I am attaching the Excel sheet that I completed my calculations on also. It is important to understand how each of these calculations will help us make the proper decision and also how each of the calculations is completed.

The payback period is the length of time that is required for Strident Marks to cover the initial investment for the proposed project (Gitman, 2006, p. 419). I have calculated the payback period for this particular project in the Excel sheet that is attached. I calculated by using the initial investment and the cash flows that were in the original data that I received about this project. The easiest way to figure this is to divide the initial investment by the cash inflows (Gitman, 2006, p. 420). We can do this because the cash inflows are the same for each year, which is $7500. Our initial investment was $10000. Therefore $10000 divided by $7500 gives us 1.33 years. This equals one year and four months to get back our initial investment. This means that the initial investment would be covered with the first year cash inflow and one/third of the second year cash inflow.

There are three major weaknesses to the payback period. The first is a major one. The data is a subjective amount (Gitman, 2006, p. 420). This means that it is not based on hard facts. It is merely a well thought out guess or estimate. The second issue is that it does not take into consideration the time value of money (Gitman, 2006, p. 421). What this means is that if you take a further look into the cash inflows for the investments, it might be better to choose one that recovers the most money the fastest (Gitman, 2006, p. 241). The third drawback is that the payback period method fails to consider the cash inflows after the payback is completed (Gitman, 2006, p. 242). This means that one investment might have a shorter payback period, but then earn less after the initial payback; where another might have a longer payback period, but earn more money after that payback is reached. The only way to properly make decisions based on the payback period is to utilize it with other methods, such as the NPV and IRR.

Net present value, NVP, is "the present value of an investment's future net cash flows minus the initial investment" (Web Finance Inc., 2007). I calculated NPV using a function in the attached Excel Sheet. The NPV of this particular project is $18,651.39. Since the NVP is greater than $0, we should accept the project based on this alone (Gitman, 2006, p. 423). To calculate NPV I had to use the discount rate and the cash inflows for each year. In order to calculate in Excel, we use the following function: =NPV(B28,C8:E8). This formula will only work with the cells listed in my Excel sheet. Cell B28 is the discount rate of 10%. Cells C8, D8, and E8 are the cash inflows of $7500 for each year. By using Excel, we eliminate a lot of problems when data is entered correctly. When using NVP you should always accept an investment that is above $0 because you will earn more money than what the actual investment will cost you and make a profit (Gitman, 2006, p. 424). If the NPV is lower than $0 and a negative number, you should always reject the investment because it means that you will be doing business at a loss and not actually earning anything or even breaking even.

The initial rate of return, IRR, is termed "as the discount rate that makes the project have a zero Net Present Value" (Odellion Research, 2006). I calculated the IRR of the particular project by using another Excel function. In order to calculate the IRR we need to know the initial investment which is $10,000 and the cash flows of each year, which were all $7500. In the Excel Sheet I used the following function: =IRR(B37:B40).

As stated with NPV, this will only work with my Excel sheet. B37 is the initial investment in Year 0 and cells B38, B39, and B40 are all the cash inflows for Years 1, 2, and 3, which is $7500. With this being stated, the IRR is 55%. The decision criteria for IRR is similar to the NPV as in terms of accept/reject (Gitman, 2006, p. 426). We should accept this project because the IRR is 55% which is greater than the 10% cost of capital. You should always accept the project if the IRR percentage is higher than the cost of capital percentage, and always reject if the IRR percentage is lower than the cost of capital percentage (Gitman, 2006, p. 426).

With the information that I have calculated we can conclude that this project is a good choice for Strident Marks and we should accept it. We can base this decision off the following facts:

-The payback period is one year and four months, which means less risk for the company because it has a shorter payback period.

-The NPV is much greater than $0 at $18,651.39, which means that we have an opportunity to earn on this project.

-The IRR percentage is greater than the cost of capital percentage at 55%, which means that we have an opportunity to earn on this project.

As you can see there is concrete data to help us make our decision on this investment. It is appropriate to accept this project with the data that I have provided.
References

Gitman, L.J. (2006). Principles of managerial finance (11^th ed). Boston, Massachusetts: Pearson Addison Wesley

Odellion Research. (2006). Internal rate of return (irr). Retrieved March 23, 2007, from Odellion Research Web site: http://www.odellion.com/pages/online%20 community/IRR/financialmodels_irr_definition.htm

Web Finance Inc. (2007). Net present value. Retrieved March 23, 2007, from Investor Words Web site: http://www.investorwords.com/3257/Net_Present_Value.html