Capital Budgeting Description

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Table of Contents

Introduction
Discounted payback period
The profitability of this investment in five years
The Internal return rate (IRR) and modified internal return rate (MIRR)
Project NPV and the investment worth
Project profitability index
References

Introduction

Basically, in capital budgeting, the speculative assessments of net present value are anchored on the suppositions of efficient and perfect markets, project life certainty as well as the absence of capital rationing. Practically, quite a number of these suppositions materialize not to be true. For instance, the net present value principle warrants only profitability and not liquidity. However, the discounted payback period criterion fulfills both the net present value and the payback period. Thus, it serves as the best and ideal decision-making criteria during the investment decision-making process. Conversely, the much-criticized payback period principle lays much emphasis on liquidity and not necessarily on project profitability (Bhandari, 1989). All these criteria are subsequently discussed and well-illustrated using the given example.

Discounted payback period

The payback period (PP) mathematically implies the period Np where ∑ Ct = Co. From the equation, Co = the initial cash outlay while Ct = the period t cash-inflow. Given the PP, the discounted payback period abbreviated as DPP denotes the period Nd where ∑ Ct / (1+k)^t = Co whereby k represents a capital cost. From the example, Co = $ 100, 000, k = 15% and Ct are as follows.

Period (t)	0	1	2	3	4	5	R1
Cash flow (Ct)	-100,000	+550,000	+605,000	+665,500	+732,050	+805,255	R2
∑ Ct	-100,000	+450,000	+1,055,000	+1,720,500	+2,452,550	+3,257,805	R3
		0≤ PP≤1
The discounted factor at 15%	1.000	0.8696	0.7561	0.6575	0.5718	0.4972	R4
Present value (PV) of cash flows	-100,000	+478,280	+457,440.50	+437,566.25	+418,586.19	+400,372.79	R5=R2*R4
Cumulative PV of cash-flows	-100,000	+378,280	+835,720.5	+1,273,286.75	+1,691,872.94	+2,092,245.73	R6
	0≤ DPP≤1					NPV
IRR and MIRR		∑ Ct / (1+k)^t				14.92%

From the above table, it emanates that the investment payback period falls between zero and one year. That is, 0≤ PP≤1. However, when the ensuing investment cash-flows are uniformly spread in a given year, the payback period will be equivalent to 0.222 years. The discounted payback period for any investment is regarded as the period in time where the accumulative investments’ present value equals zero (Shapiro, 1981). Therefore, the investment computation above indicates that the discounted payback period falls between zero and one year. To be precise, the discounted payback period for this particular investment is 0.26 years, given by 100, 000 / +378,280.

The profitability of this investment in five years

This investment project that William Pharmaceutical management intends to initiate is acceptable given that the discounted payback period falls between zero and one year (0≤ DPP≤1). This period is actually within the expected investment life which is five years. The investment acceptance is viable given that the DPP is not more than the project set five years lifespan. Positive profits start to accrue in the 0.222 years.

The Internal return rate (IRR) and modified internal return rate (MIRR)

Ideally, IRR and MIRR are similar techniques. In fact, MIRR is perceived as the project IRR when investments are identical. From the discounted values totaling to 4.3522 and NPV =$2,092,245.73, IRR = 2,092,245.73/ (1 + r)⁵= (2,092,245.73)^1/5 = (1 + 1.58) * 10 = 25.75%. Thus, in the next five years, the company expects a MIRR equivalent to 25.75%.

Project NPV and the investment worth

The NPV rules stipulate that provided the project NPV ensues to be positive, it is deemed viable to undertake such a project. This would imply that the project generates above the required return rate. When the NPV emanates to be negative, it is not worth undertaking such a project since it will be decreasing the corporation value as well as the stakeholders’ wealth. Nevertheless, zero NPV tends to make the management appear indifferent as regards assuming a given investment (Levy, 1968). Zero NPV implies that the investment only generates the required return rate to the stakeholders. Given that this investment’s net present value equals $2,092,245.73, it is apparent that it is greater than zero hence worth this project investment. Therefore, both the NPV and DPP criteria give similar conclusions which make this particular project to acceptable.

Project profitability index

In capital budgeting, the project profitability index (PPI) is always given by the formula: PPI = The projected net present value / the investment necessary for that project. For this particular, investment, the PPI = $2,092,245.73 / 100, 000 = 20.92. Since the PPI assumes that any fund which an investment releases become reinvested in various other undertaken projects at a return rate equivalent to the discount rate, it accrues to be the best method to rank competing investment projects.

References

Bhandari, Shyam (1989). Discounted payback period: A viable complement to net present value for projects with conventional cash flows. The Journal of cost analysis, pp. 43-53.

Levy, Haim (1968). A note on the payback period. Journal of Finance and Quantitative Analysis, pp. 433-445.

Shapiro, Alan (1981). Managing political risk: A policy approach. Columbia Journal of World Business, pp. 63-68.

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