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Capital Expenditures

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Introduction

Capital Expenditures Capital expenditures have a significant impact on the financial performance of the firm; therefore, criteria for selecting projects must be evaluated with great care. Of the two corporations the firm is deciding to acquire, Corporation B is clearly the better investment as shown in Table 1 supported by the following data: net present value (NPV), internal rate of return (IRR), payback period, profitability index (PI), discounted payback period, and modified internal rate of return (MIRR) in addition to 5 year projections of income and cash flows. Decision Method Corp A Corp B NPV 20,979 40,252 IRR 13.05% 16.94% MIRR 11.79% 14.36% PI 8.39% 16.10% Payback 4.64 4.31 Discounted Payback 4.40 4.76 Table 1: Decision Method Results (See Excel Spreadsheet for details) The 5 year projections of both Corporations A and B's income statements and cash flows indicate that between the two corporations, Corporation B will maximize the firm's value the most. This decision is further evidenced by the net present value obtained for both corporations. NPV is defined as the sum of the present values of the annual cash flows minus the initial investment. If the net present value (NPV) of all cash flows is positive, the project will be profitable. The NPVs for both corporations suggest that both projects are worthwhile, since each has a positive NPV, however, since the firm can only acquire one of the corporations, it must choose the acquisition of the corporation with a higher NPV - Corporation B. ...read more.

Middle

Again, while acquisitions of either corporation will benefit the firm, the MIRR supports the acquisition of Corporation B over Corporation A since Corporation B has a higher MIRR than Corporation A. The profitability index (PI) is defined as the ratio of the present value of the future free cash flows to the initial outlay. Corporation A provides a PI of 8.39% while corporation B provides a PI of 16.10%. Since profitability indexes are greater than 1.0 for both corporations, acquisition of either company will benefit the firm. However, data show that the present value of future benefits from Corporation B is greater than that of Corporation A. Corporation B will have 16.10% times the level of the initial outlay while Corporation A will have 8.39% times the level of the initial outlay. This decision supports the recommendation made based on NPV, IRR and MIRR rules. When resources are limited and a choice must be made between competing projects as is the case for this firm, the profitability index is a good investment criteria as it takes into account NPV for each dollar invested. The payback period represents the amount of time that it takes for a capital budgeting project to recover its initial cost. When choosing projects, the project with the quickest payback should be chosen. Acquisition of Corporation B would payback the initial cost in 4.31 years while Corporation A would payback in 4.64 the difference of which is negligible. ...read more.

Conclusion

Year 1 Year 2 Year 3 Year 4 Year 5 Revenues 150000 162000 174960 188957 204073 Expenses 60000 66000 72600 79860 87846 Depreciation 10000 10000 10000 10000 10000 Earnings Before Interest and Taxes 80000 86000 92360 99097 106227 Taxable Income 80000 86000 92360 99097 106227 Taxes (25%) 20000 21500 23090 24774 26557 Net Income 60000 64500 69270 74323 79670 Corporation A Cash Flow Corporation B Cash Flow Discount Rate 0.1 0.11 Year 0 -250000 -250000 1 61250 70000 2 66500 74500 3 72163 79270 4 78262 84323 5 84823 89670 PV of future Cash Flows $270,980 $290,251 NPV $20,980 $40,251 IRR 13.05% 16.94% Profitability Index 8.39% 16.10% Modified IRR 11.79% 14.36% Corp A Cash Flow Corp A Net Cash Flow Corp B Cash Flow Corp B Net Cash Flow Year 0 -250000 -250000 -250000 -250000 1 61250 -188750 70000 -180000 2 66500 -122250 74500 -105500 3 72163 -50087 79270 -26230 4 78262 28175 84323 58093 5 84823 112998 89670 147763 Payback Period 4.64 4.31 Payback Period = Last year with a negative NCF + (Absolute value of NCF in that year/Total CF the following year) Corporation A Cash Flow Corp A Discounted CF Corp A Running Total Corporation B Cash Flow Corp B Discounted CF Corp B Running Total Year 0 -250000 -250,000 -250,000 -250000 -250000 -250000 1 61250 55682 -194318 70000 63063 -186937 2 66500 54959 -139360 74500 60466 -126471 3 72163 54217 -85142 79270 57962 -68510 4 78262 53454 -31688 84323 55546 -12963 5 84823 52668 20980 89670 53215 40251 Discounted Payback Period 4.40 4.76 ...read more.

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