What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions?
Capital budgeting is the process of analyzing potential additions to fixed assets. Capital budgeting is very important to firm’s future because of the fixed asset investment decisions chart a company’s course for the future. The firm’s capital budgeting process is very much same as those of individual’s investment decisions. There are some steps involved. First, estimate the cash flows such as interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects. Second is to assess the riskiness of the cash flows. Next, determine …show more content…
This is because the IRR for project S is 23.56% and it is higher compared to the IRR for project L which only 18.13%.
4) Would the projects’ IRR change if the WACC changed?
No, the IRR would not change if the WACC changed.
Question e 1) What is the underlying cause of ranking conflicts between NPV and IRR?
In the normal project for the NPV profiles to cross one project must have both a higher vertical axis intercept and a steeper slope than the other. A project’s vertical axis typically depends on the size of the project and the size and timing pattern of the cash flows. For example, for the large projects and with large distant cash flows would expect to have relatively high vertical axis intercepts. The slope of the NPV profile depends entirely on the timing pattern of the cash flows. The long-term projects have steeper NPV profiles compared with short-term projects. So, NPV can only cross in two situations which is when mutually exclusive projects differ in scale or size and when the projects’ cash flows differ in terms of the timing pattern of their cash flows (Project L and S).
2) What is the “reinvestment rate assumption”, and how does it affect the NPV versus IRR conflict?
The underlying cause of ranking conflict is the reinvestment rate assumption. All DCF methods assume that cash flows can be reinvested at some rate. This applies to Project L and S. When