The results are shown in Table 1.
The internal rate of return is the cost of capital that will equate the present value of future cash flows to zero. In other words, it is the required rate of return which will yield a zero NPV. Thus, equation 1 can be modified such that NPV is replaced by 0. NPV calculations can be done manually but the process is tedious as it requires calculating the NPV by using different values of cost of capital. Another is the use of software like Microsoft Excel to generate a more accurate figure.
The decision whether the project should be accepted or not will be based on the results of the financial and strategic analyses using techniques like NPV and IRR. In using NPV as a tool, the general rule is to accept projects or investments which generates a positive NPV while reject those which yields negative NPV. The result of the NPV has a direct implication on the value of IRR relative to the required rate of return. Accordingly, a project is pursued if the IRR is equal to or higher than the required rate of return. In contrast, a project with a lower IRR than the cost of capital is turned down. It should be noted that a positive NPV is indicative of an IRR which is higher than the required rate of return.
The project considered by Fijisawa, which is ...
Accordingly, a project is pursued if the IRR is equal to or higher than the required rate of return. In contrast, a project with a lower IRR than the cost of capital is turned down. It should be noted that a positive NPV is indicative of an IRR which is higher than the required rate of return.
The project considered by Fijisawa, which is the expansion of its product line should be accepted based on the quantitative analyses using NPV and IRR techniques. The investment yields a relatively high NPV of 9,235,200. The IRR of 33.996% is very high compared to the required rate of return of 9%. Thus, Fijisawa will reap higher benefits than its capital outlay in the proposed project.
However, it should also be noted that quantitative analyses are often not enough in ascertaining whether an investment should be pursued or not. Though expansion of the product is quantitatively profitable, qualitative factors like consumer demand and others should also be taken into account.
2. Why is the capital budgeting decision such an important process Why are capital budgeting errors so costly
Capital budgeting is an extremely important aspect of a business organization's financial management. Capital budgeting is defined as the "decision making process used in the acquisition of long term physical assets (Capital Budgeting 2006)." These long term investments can be the replacement of the current machinery, the acquisition of new equipment, establishment of new plants, introduction of new products, and investment in research and development activities.
The importance of capital budgeting in a company cannot be overstated. Chatfield and Dalbor (2004) stressed that capital budgeting decisions are very much crucial in maintaining the firm's long-run financial