## Overview

Assessment 9

Respond to four questions and solve two computational problems about the capital budgeting process.

The capital budgeting process is a method used by organizations to evaluate their investment in various projects, such as buying new machinery or expanding into a new plant. You will benefit from being able to demonstrate the use of the capital budgeting process, including the following techniques and terms:

• Net present value (NPV) method.

• Internal rate of return (IRR) method.

• Modified internal rate of return (MIRR) method.

• Payback period.

• Discounted payback period.

• Profitability index.

By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:

• Competency 2: Define finance terminology and its application within the business environment.

o Identify the benchmark when using net present value (NVP).

o Explain the payback period statistic.

o Identify the payback period statistic acceptance benchmark.

o Calculate the internal rate or return (IRR) and modified rate or return (MIRR) for a project.

o Calculate the net present value (NVP) for a project.

• Competency 3: Evaluate the financial health of an organization.

o Explain the net present value (NVP) method for determining a capital budgeting project’s desirability.

o Describe the internal rate of return (IRR) method for determining the desirability of a capital budgeting project.

o Identify the internal rate of return (IRR) acceptance benchmark of a capital budgeting project.

o Describe the modified internal rate of return (MIRR) method for determining the desirability of a capital budgeting project.

o Identify the strengths and weaknesses of modified internal rate of return (MIRR).

o Explain whether a project should be accepted or rejected, based on the calculated IRR and MIRR.

Use references to support your responses as needed. Be sure to cite all references using correct APA style. Your responses should be free of grammar and spelling errors, demonstrating strong written communication skills.

Assessment Instructions

Respond to the questions and complete the problems.

Questions

In a Word document, respond to the following. Number your responses 1–4.

1. Explain the net present value (NPV) method for determining a capital budgeting project’s desirability. What is the acceptance benchmark when using NPV?

2. Explain the payback period statistic. What is the acceptance benchmark when using the payback period statistic?

3. Describe the internal rate of return (IRR) as a method for deciding the desirability of a capital budgeting project. What is the acceptance benchmark when using IRR?

4. Describe the modified internal rate of return (MIRR) as a method for deciding the desirability of a capital budgeting project. What are MIRR’s strengths and weaknesses?

Problems

In either a Word document or Excel spreadsheet, complete the following problems.

• You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet.

• If you choose to solve the problems algebraically, be sure to show your computations.

• If you use a financial calculator, show your input values.

• If you use an Excel spreadsheet, show your input values and formulas.

In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer.

1. Based on the cash flows shown in the chart below, compute the NPV for Project Huron. Suppose that the appropriate cost of capital is 12 percent. Advise the organization about whether it should accept or reject the project.

Project Huron

Time 0 1 2 3 4

Cash Flow $12,000 $2,360 $4,390 $1,520 $3,300

2. Based on the cash flows shown in the chart below, compute the IRR and MIRR for Project Erie. Suppose that the appropriate cost of capital is 12 percent. Advise the organization about whether it should accept or reject the project.

Project Erie

Time 0 1 2 3 4 5

Cash Flow $12,000 $2,360 $4,390 $1,520 $980 $1,250

Suggested Resources:

The following optional resources are provided to support you in completing the assessment or to provide a helpful context.

Library Resources:

• Weaver, S. C., & Weston, J. F. (2001). Finance and accounting for nonfinancial managers. New York, NY: McGraw-Hill.

• Sherman, E. H. (2011). Finance and accounting for nonfinancial managers (3rd ed.). New York, NY: American Management Association.

Course Library Guide

You are encouraged to refer to the resources in the BUS-FP3062 – Fundamentals of Finance Library Guide to help direct your research.

Other Resources

• Cornett, M., Adair, T., & Nofsinger, J. (2019). M: Finance (4th ed.). New York, NY: McGraw-Hill. Available in the courseroom via the VitalSource Bookshelf link.

** ****Capital Budgeting Techniques**

**1.**

According to Jory et al. (2016), the net present value is an investment appraisal technique that shows an investment project’s effect on shareholders’ wealth in present value terms. Put differently; the net present value tests a project’s desirability by estimating the present value of a project’s estimated future cashflows. This method starts with discounting the future cash flows of a project using the provided discount rate. After discounting the future cash flows, the results are summed to obtain the total discounted future cash flows. Afterwards, investors deduct the initial investment from the sum of discounted future cash flow and use the results to assess the project’s desirability.

The NPV has various acceptance criteria that vary depending on whether the focus is on independent or mutually exclusive projects. The first criteria provide that if a project’s NPV is positive or greater than $0, investors should accept it. Similarly, in mutually exclusive projects, investors should take projects that have a higher NPV.

The payback period is a popular technique for evaluating capital budgeting decisions. As the literature suggests, this statistic evaluates capital budgeting decisions by assessing the number of years it would take to recover project investment costs (Al-Ani, 2014). In essence, the payback period statistic assesses a project’s desirability by examining the duration required to recover the initial investment. The payback period statistics are calculated using two approaches; the averaging method involves a division of the annualized cash flows by the capital investment; and the subtraction method where annual cash inflow is subtracted from the original cash inflow until it reaches the payback period.

Like the NPV, payback period statistic has an acceptance benchmark that determines whether investors should accept a project. Notably, a project’s acceptance benchmark using this method is if the allowable payback period is less than the calculated payback period for independent projects. In mutually exclusive projects, the acceptance benchmark is the project with the least payback period.

Reniers et al. (2016) describe the internal rate of return as the discount rate at which the present value of future cashflows break even. Put differently, the internal rate of return is the discount rate at which a project’s present value of future cash flows is similar to the initial capital investment. Often, investors calculate the internal rate of return through a trial-and-error technique that involves calculating the difference between an investment’s future value and its beginning cashflow and multiplying the results by 100 to get the rate in percentage. Like other capital budgeting techniques, the internal rate of return has an acceptance benchmark. Notably, the approach’s decision rule provides that if a project’s internal rate of return is equal or greater than the initial capital investment, investors should accept the project. Similarly, if the internal rate of return is less than the initial capital, investors should reject the project.

Modified internal rate of return is a capital budgeting tool that assesses a project’s desirability by ranking investments of equal size. This tool assumes that a firm’s positive cashflows during a project’s life are reinvested at the internal rate of return while a firm’s financing cost funds the initial outlay of a project.

The MIRR, which is considered an improved version of the internal rate of return has some benefits and drawbacks. On the one hand, the technique eliminates the IRR drawbacks by including investments with unusual cashflow timings. Moreover, the method takes a further step to assess an investment’s sensitivity to capital costs variation. Conversely, the modified internal rate of return does not quantity an investments’ impact on investors’ wealth, leading to suboptimal decision-making in mutually exclusive investments.

References

Al-Ani, M.K. (2015). A strategic framework to use payback period in evaluating the capital budgeting in energy and oil and gas sectors in Oman. *International Journal of Economics and Financial Issues, 5*(2), 469-475. http: www.econjournals.com

Jory, S.R., Benamraoui, A., Boojihawon, D.R., & Madichie, N.O. (2016). Net present value analysis and the wealth creation process: A case illustration. *The Accounting Educators’ Journal, 26*(1), 85-99. http://eprints.soton.ac.uk/id/eprint/404942

Reniers, G., Talarico, L., & Paltrinieri, N. (2016). Dynamic risk analysis in the chemical and petroleum industry. *Evolution and Interaction with Parallel Disciplines in the Perspective of Industrial Application*, 195-205. https://doi.org/10.1016/B978-0-12-803765-2.00016-0