What is Capital Budgeting - Statistics Project Example

Recommendation Synergy considerations should outweigh the arithmetic of valuation in acquisitions (Damodaran, 1994, p287). I do not feel that the information provided is adequate to reach any conclusion on which of the two corporations are better for acquisition, but recommend the acquisition of corporation B because it offers a slightly better IRR. This assumes that the strategic fit of both alternatives is the same. The Discounted Cash Flow method has important limitations and may lead to erroneous decisions if seen in isolation (Trigeorgis, 1995, p 17). However, there is no basis to make a better or more firm recommendation. NPV The NPV for corporation B is also higher than for corporation A. The difference is not very significant at less than 10%, but in the absence of other information, it would appear that corporation B fetches higher present value. The NPV represents today's value of projected future cash flows. The rate of discounting should approximate the bank rate, and the 10% figure given should be seen in this context. The difference in NPV between the two alternatives would be inadequate to support any decision, given that there would inevitably be some uncertainty in the projections of revenue and cost. IRR The IRR is higher for corporation B than for corporation A. Since the company has limited funds to invest and since each of the alternatives requires equal funding, corporation B is a better choice in terms of IRR. IRR is the most relevant measure in this case, since the firm has limited funds and has to make a choice between the two corporations available for acquisition. Again, the difference in IRR between the two corporations is too small to support any decision in real life. Pay-back The Pay-back period is the same for both corporations, so no difference can be made on this account. Both corporations are equal in terms of pay-back period. The pay back figure is easy to calculate, but it can be misleading. Acquisition of a corporation should consider risks inherent in its projected earnings and continued revenues (Jean-Jacques, 2002, p55). The pay-back figure would not be an important consideration unless a diversification in to a highly risky line of business was to be involved. Future cash flows that have not been discounted do not have much value in a business situation. Profitability Profitability is better in the case of corporation A. This could be because corporation B has secured a bigger market share through price competition, and seems to have a policy of cutting margins in order to retain its market position and business volume. It may be a matter for management intervention after acquisition, for declining margins are most often difficult to reverse and can affect the long-term financial health of an enterprise. Discounted Pay back The discounted pay back period is one year more than if we consider nominal values of annual cash flows. This is the case with both corporations. This measure is more meaningful than plain pay-back. The effect of discounting is almost the same for both corporations, delaying pay-back by about a year. The discounted pay-back in the fifth year is not particularly attractive. Modified IRR The modified IRR is better with corporation B. However, the difference between the two is not significant. There is no information about other and continuing investment opportunities for the company hence the modified IRR is not as significant as in the case of an institution with a regular flow of projects. It may be argued that it is prudent to use the more stringent MIRR method, especially since the IRR itself is more than twice the rate chosen for NPV discounting. IRR and NPV The relationship between NPV and IRR is that NPV discounts future cash flows at a fixed rate (that is 10% in this example). IRR on the other hand, discounts future cash flows at the opportunity cost of capital for the company, which in this case is around 25%. The NPV is good enough if the company has no choice between acquiring corporation A or B. The IRR would come in to play if the company had several divisions competing for alternate use of limited funds. This is usually the case in the real world, because of which most management would use IRR more than NPV alone. Project Duration The period over which projections are considered should be the same in both cases. This would be 5 years in the present instance if corporation A were unable to supply forecasts for years 6 and 7. The discounting rate of 10% is relatively high, so the cash flows in year 6 and at project end can make a major difference to a decision. Declining profitability forecast by corporation B is a significant factor, because we would need to know how corporation A were to view its margins and price sensitivity of demand after year 5. It is a norm to project revenues and costs over a 10 year period, and it does not bode well for a business that is unable to see beyond 5 years. The discounted pay back is in the fifth year, so projections for only this period would not be adequate for a final management decision. The Spreadsheet Capital Budgeting Assignment Feb 2006 Corporation A in $'000 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Investment -250 225 Revenues 100 110 121 133 146 Expenses -20 -23 -26 -30 -35 Depreciation -5 -5 -5 -5 -5 Investment WDV -245 -240 -235 -230 -225 Profit before tax 75 82 90 98 106 Tax -19 -21 -22 -24 -27 Profit after tax 56 62 67 73 80 Cash flow -250 61 67 72 78 85 225 Cum. Cash flow -250 -189 -122 -50 28 113 338 NPV@10% 135 IRR 0.25 Discounted cash flows -250 56 55 54 53 53 127 Discounted cum. Cash flow -250 -194 -139 -85 -32 21 148 Pay back 4th year Discounted Pay back 5th year Profitability Index 56 56 56 55 55 Modified IRR 0.25 Corporation B Investment -250 200 Revenues 150 162 175 189 204 Expenses -60 -66 -73 -80 -88 Depreciation -10 -10 -10 -10 -10 Investment WDV -240 -230 -220 -210 -200 Profit before tax 80 86 92 99 106 Tax -20 -22 -23 -25 -27 Profit after tax 60 65 69 74 80 Cash flow -250 70 75 79 84 90 200 Cum. Cash flow -250 -180 -106 -26 58 148 348 NPV@10% 146 IRR 0.27 Discounted cash flows -250 64 62 60 58 56 113 Discounted cum. Cash flow -250 -186 -125 -65 -8 48 161 Pay back 4th year Discounted Pay back 5th year Profitability Index 40 40 40 39 39 Modified IRR 0.26 Formulae and Audit Trace Capital Budgeting Assignment Feb 2006 Corporation A in $'000 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment -250 Revenues 100 =(C5*1.1) =(D5*1.1) =(E5*1.1) =(F5*1.1) Expenses -20 =(C6*1.15) =(D6*1.15) =(E6*1.15) =(F6*1.15) Depreciation -5 -5 -5 -5 -5 Investment WDV =(B4)-(C7) =(B4)-(C7+D7) =(B4)-(C7+D7+E7) =(B4)-(C7+D7+E7+F7) =(B4)-(C7+D7+E7+F7+G7) Profit before tax =(C5+C6+C7) =(D5+D6+D7) =(E5+E6+E7) =(F5+F6+F7) =(G5+G6+G7) Tax =-(C9*0.25) =-(D9*0.25) =-(E9*0.25) =-(F9*0.25) =-(G9*0.25) Profit after tax =(C9+C10) =(D9+D10) =(E9+E10) =(F9+F10) =(G9+G10) Cash flow -250 =(C11-C7) =(D11-D7) =(E11-E7) =(F11-F7) =(G11-G7) Cum. Cash flow =(B12) =(B13+C12) =(C13+D12) =(D13+E12) =(E13+F12) =(F13+G12) NPV@10% =NPV(0.1,B12,C12,D12,E12,F12,G12,H12) IRR =IRR(B12:H12) Discounted cash flows -250 =(C12/1.1) =(D12)/(1.1*1.1) =(E12)/(1.1*1.1*1.1) =(F12)/(1.1*1.1*1.1*1.1) =(G12/(1.1*1.1*1.1*1.1*1.1)) Discounted cum. Cash flow =(B16) =(B17+C16) =(C17+D16) =(D17+E16) =(E17+F16) =(F17+G16) Pay back 4th year Discounted Pay back 5th year Profitability Index =(C11/C5)*100 =(D11/D5)*100 =(E11/E5)*100 =(F11/F5)*100 =(G11/G5)*100 Modified IRR =MIRR(B12:H12,0.1,0.25) Corporation B Investment -250 Revenues 150 =(C24*1.08) =(D24*1.08) =(E24*1.08) =(F24*1.08) Expenses -60 =(C25*1.1) =(D25*1.1) =(E25*1.1) =(F25*1.1) Depreciation -10 -10 -10 -10 -10 Investment WDV =(B23)-(C26) =(B23)-(C26+D26) =(B23)-(C26+D26+E26) =(B23)-(C26+D26+E26+F26) =(B23)-(C26+D26+E26+F26+G26) Profit before tax =(C24+C25+C26) =(D24+D25+D26) =(E24+E25+E26) =(F24+F25+F26) =(G24+G25+G26) Tax =-(C28*0.25) =-(D28*0.25) =-(E28*0.25) =-(F28*0.25) =-(G28*0.25) Profit after tax =(C28+C29) =(D28+D29) =(E28+E29) =(F28+F29) =(G28+G29) Cash flow -250 =(C30-C26) =(D30-D26) =(E30-E26) =(F30-F26) =(G30-G26) Cum. Cash flow =(B31) =(B32+C31) =(C32+D31) =(D32+E31) =(E32+F31) =(F32+G31) NPV@10% =NPV(0.1,B31,C31,D31,E31,F31,G31,H31) IRR =IRR(B31:H31) Discounted cash flows -250 =(C31/1.1) =(D31)/(1.1*1.1) =(E31)/(1.1*1.1*1.1) =(F31)/(1.1*1.1*1.1*1.1) =(G31/(1.1*1.1*1.1*1.1*1.1)) Discounted cum. Cash flow =(B35) =(B36+C35) =(C36+D35) =(D36+E35) =(E36+F35) =(F36+G35) Pay back 4th year Discounted Pay back 5th year Profitability Index =(C30/C24)*100 =(D30/D24)*100 =(E30/E24)*100 =(F30/F24)*100 =(G30/G24)*100 Modified IRR =MIRR(B31:H31,0.1,0.25) References Damodaran, A, 1994, Damodaran on Valuation, John Wiley and Sons Jean-Jacques, J. D. 2002, The 5 Keys to Value Investing, McGraw-Hill Professional Trigeorgis, L, 1995, Real Options in Capital Investment, Praeger/Greenwood Read More