Capital Budgeting Case Study
When making financial investments it is crucial to have a complete understanding of the financial aspects of the corporation being acquired. Making wise decisions requires knowledge of the relationships between statistics and projected balances. Ratios, present values, and rates of return should all be considered before making large financial decisions. When presented with multiple investment opportunities comparison of calculations based on projected cash flows enables an investor to make well educated decisions based on predicted financial returns.
The Net Present Value (NPV) is a method of analyzing and appraising the earning potential of investments. The NPV is the difference between cash flow coming in and going out and provides a comparison of the time value of money (Bierman, 1977). In this capital budgeting case study, the NPV is used to determine which corporation is the better investment. The rule regarding the NPV is to accept investments with a net present value greater than zero and decline investments with a net present value less than zero (Bierman, 1977). For instance, when choosing between two investment opportunities if both companies have an NPV higher than zero, the investment with the higher NPV would be the better choice because the value of return is higher.
According to Investopedia, the Internal Rate of Return (IRR) is defined as the economic rate or discount rate used in capital budgeting to determine acceptable investments (2014). The IRR makes the NPV of an organization’s cash flow equal to zero. According to Investopedia, "you can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth analyzing corporations" (2014). The rationale behind IRR calculations is a single percentage that is used to determine the profitability of the investment and does not take into consideration the current interest rate within the market.
Both NPV and IRR use a discount rate to determine if an investment will generate enough cash flow to recover the original investment (Velez-Pareja, 2013). NPV uses a discount rate to calculate a dollar amount of expected return on the original investment. Using NPV calculations in capital investments enables an investor to verify that the investment has enough cash flow to recover the cost of the original investment and identify the best investment opportunities. IRR calculations use a specific percentage rate that results in the cash flows present value equaling the original investment