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.

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.

The Internal Rate of Return, IRR, is another business tool used for capital budgeting decision. IRR is the discount rate at which the present value of a series of investments is equal to the present value of the returns on those investments (NPV = 0). It is the compound return the firm will get from the project. IRR also takes into account the time value of money by considering the cash flows over the lifetime of a project. If IRR is greater than the discount rate, the firm may undertake the project in question. In this situation, acquisition of either corporation is worthwhile since each has an IRR greater than their respective discount rates, but since IRR gives the project’s compound rate of return, the project providing the higher compound rate of return should be selected which means that Corporation B is preferred to Corporation A. Both NPV and IRR analyses support the acquisition of Corporation B. In cases where a conflict exists between NPV and IRR as to which competing projects to choose, the project with the larger NPV should be selected. That is, the NPV criterion is the correct criterion to use for capital budgeting since NPV measures the incremental wealth from undertaking a project and stockholders are interested in maximizing their wealth, not their rate of return. IRR is not a good measure of capital budgeting decision by itself given that it may give ambiguous results. In addition, it is critical to choose the appropriate discount rate relative to the riskiness of the project’s cash flows to have the assurance that the present value of the investment will in fact be realized by the firm. It is worth noting that if the cash flows are discounted at the IRR rate, NPV will be zero.

The MIRR or Modified Internal Rate of Return is yet another criterion for capital budgeting decision. It is basically the Internal Rate of Return adjusted for negative cash flows. MIRR better reflects the profitability of a project as it assumes that all cash flows are reinvested at the firm’s cost of capital, whereas the IRR assumes the cash flows from the project are reinvested at the IRR. 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 ...

This is a preview of the whole essay

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. It should be noted that the use of payback period as a decision rule has several flaws. It does not take into account the time value of money nor does it consider all of the project’s cash flows. In deciding which project to take, the main concern should be on how the investment will affect the value of the firm’s stock more so than how long it takes to recover the investment that presupposes that the project does add value for stockholders.

When using the payback period as a criterion for capital budgeting decision, it is better to use the discounted payback as it takes into account the time value of money although still inferior to NPV. In both projects, the initial cost is recovered even after discounting the cost of capital. In this situation, however, the difference in discounted payback period is negligible.

In summary, after review of the 5 year projections of cash flows for both corporations and all other supporting data provided in this report, the firm should proceed with the acquisition of Corporation B. Had the firm have unequal projected years available to them for review, for instance, Corporation A had a 5 year projection of cash flows and Corporation B with a 7 year projection of cash flows, the decision outcome should be no different since analysis of NPV, IRR, MIRR, PI, payback period and discounted payback period will be carried out for the respective cash flows.

Appendix A: Supporting Data (see Excel attachment for calculations)