Capital budgeting is a process where business executives plan about the future of their company. The company looks at potential investments, and they must decide if the investment is worth being funded by the company’s current capital. The process involves decisions that will affect the company’s long-term business structure. In our capital budget case we had to choose between two corporations that are available for sale. As executives, we must look at the most logical corporation to invest in. We have calculated the projected income statement and projected cash flow for the next five years. After evaluating that information we were able to view the net present value and internal rate of return. Based off the findings of our research, we will be able to make a decision on the appropriate investment.
The net present value and internal rate of return are capital budgeting methods that can be used to calculate the potential capital of an investment. It is used as a tool to determine if a potential investment is worthwhile. A firm needs to decide whether the investment will generate net economic profits or losses for the company (Gallant, 2009). In this case we used these methods to compare two corporations. The two corporations are listed at the same price; therefore, the net present value and internal rate of return will carry much of the weight in determining which corporation that our company will purchase.
According to the text, the NPV is superior in comparison to the IRR. “One disadvantage of the IRR relative to the NPV deals with the implied reinvestment rate assumptions made by these two methods. The NPV assumes that cash flows over the life of the project are reinvested back in projects that earn the required rate of return. The use of the IRR, however, implies that cash flows over the life of the project can be reinvested at the IRR.” (Arthur J. Keown, 2014) Based off the suggestions from the text, one would assume that the final decision on the investment should be determined by which by which opportunity has the higher NPV.
The text also states the easiest way to understand the relationship between the IRR and the NPV value is to view it graphically. A net present value profile is a graph showing how an investment’s NPV changes as the discount rate changes. To graph an investment’s net present value profile, you simply need to determine the project’s NPV, first using a 0 percent discount rate, and next you must slowly increase the discount rate until a curve has been plotted. How does the IRR enter into the net present value profile? The IRR is the discount rate at which the NPV is zero. (Arthur J. Keown, 2014)
In the cases of Corporation A and Corporation B the best option concerning acquiring another corporation would be Corporation B. First there is a difference in the NPV whereas Corporation A is 20,979.20 at 10% and Corporation B is 40,251.47 at 11% based on the net present value. According to this analysis the NPV for Corporation B is greater than Corporation A which addresses the present money of today to the present value of money of the future. If the net present value of any project or investment is positive then only that investment is accepted otherwise it should be rejected, as the NPV is negative. If the NPV is zero then it is projected that it is positive. The NPV is the best technique available these days and is reliable concerning more accurate results. If the discount rate does change then the result will also be changed.
As for the IRR between Corporation A and Corporation B the differences are 13.05% and 16.94%. Again, the