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Capital Budgeting Case Study

Capital Budgeting Case Study Kim Berkley QRB501 August 20, 2013

Capital Budgeting Case Study

Capital Budgeting Case Study

When thinking about acquiring another corporation it is important to analyze it completely in order to make informed decision. Many companies use capital budgeting in order to figure out what would be best when it comes to investing in capitalized expenditure. Things that will be capitalized are the things acquired that will be depreciated over time. Along with other corporations, a capital expenditure can also be equipment and buildings. There are a number of capital budget tools that can be used in making the decision of acquiring a new corporation. Two of them are net present value (NPV) and internal rate of return (IRR). The net present value (NPV) of an investment proposal is equal to the present value of its annual free cash flows less the investments initial outlay (Keown, Martin, & Petty, PhD., 2014, p. 310). The NPV measures the net value of the proposed investment in terms of dollars today. Hence the words present value. It gives you the present day value of the investment. If the NPV is greater than or equal to zero, you should accept the investment. If the NPV is negative, you should reject the project. In cased where the investment NPV is zero and it has an acceptable rate of return you should accept it. The internal rate of return is defined as the discount rate that equates the present value of the projects free cash flows with the projects initial cash outlay (Keown, Martin, & Petty, PhD., 2014, p. 316). When IRR is more than the discount rate then you should choose to invest and when it is less than the discount rate you should chose not to invest. In order to even get to the point of calculating the NPV and IRR we must first create an income statement and projected cash flow. It was decide to do five years on both. Each corporation costs $250,000 to acquire and only one can be acquired. Other given information and the results for both the income statements and cash flow are below:

Corporation A Revenues = $100,000 in year one, increasing by 10% each year Expenses = $20,000 in year one, increasing by 15% each year Depreciation expense = $5,000 each year

Capital Budgeting Case Study Tax rate = 25% Discount rate = 10% Corporation B Revenues = $150,000 in year one, increasing by 8% each year Expenses = $60,000 in year one, increasing by 10% each year Depreciation expense = $10,000 each year Tax rate = 25% Discount rate = 11%
C om pa nyAIncom eS ta tem ent
Year 0 Revenue Expenses Depreciation Expense $ Total Expences Taxes (25%) Net Income $ -

Yea r1

Yea r2

Y ea r3

Y ea r4

Y ea r5
34,980.13 5,000.00 39,980.13 26,607.47 79,822.41

$ (250,000.00) $ 100,000.00 $ 110,000.00 $ 121,000.00 $ 133,100.00 $ 146,410.00 $ 20,000.00 $ 23,000.00 $ 26,450.00 $ 30,417.50 $ $ 5,000.00 $ 5,000.00 $ 5,000.00 $ 5,000.00 $ $ 25,000.00 $ 28,000.00 $ 31,450.00 $ 35,417.50 $ $ 18,750.00 $ 20,500.00 $ 22,387.50 $ 24,420.63 $ $ 56,250.00 $ 61,500.00 $ 67,162.50 $ 73,261.88 $

C om pa nyBIncom eS ta tem ent


Revenue $ (250,000.00) Expenses Depreciation Expense $ Total Expences Taxes (25%) Net Income $ $ $ $ $ $ $

Yea r1
150,000.00 60,000.00 10,000.00 70,000.00 20,000.00 60,000.00 $ $ $ $ $ $

Yea r2
162,000.00 66,000.00 10,000.00 76,000.00 21,500.00 64,500.00

Y ea r3
$ 174,960.00 $ 72,600.00 $ 10,000.00 $ 82,600.00 $ 23,090.00 $ 69,270.00 $ $ $ $ $ $

Y ea r4
188,956.80 79,860.00 10,000.00 89,860.00 24,774.20 74,322.60

Y ea r5
$ 204,073.34 $ 87,846.00 $ 10,000.00 $ 97,846.00 $ 26,556.84 $ 79,670.51

Expected after-tax net cash flows (CFt) Year (t) 0 1 2 3 4 5 Corp. A. Corp. B. $ (250,000.00) $ (250,000.00) 56,250 60,000 61,500 64,500 67,163 69,270 73,262 74,323 79,822 79,671

Now after looking at the information above one would think that acquiring Corporation A would be the best option because it is projected to bring in a slightly higher net income by year 5. This would seem to mean that in the long run this company would be more profitable. In order to fully know which corporation would be best we have to also take a look at the NPV and IRR. These results are below:

Capital Budgeting Case Study


Net Present Value (NPV) discount rate: Corp. A. 10% Time period: Cash flow: Disc. cash flow: NPV(A) = discount rate: Corp. B. $2,025.27 11% Time period: Cash flow: Disc. cash flow: NPV(B) = $3,292.50 0 (250,000) (250,000) 1 60,000 54,054 2 64,500 52,350 $ 3 69,270 50,650 3,292.50 4 74,323 48,959 5 79,671 47,281 0 (250,000) (250,000) 1 56,250 51,136 2 61,500 50,826 or 3 67,163 50,460 $2,025.27 4 73,262 50,039 5 79,822 49,563

= Sum disc. CF's.

= Uses NPV function.

Internal Rate of Return Expected after-tax net cash flows (CFt) Year (t) 0 1 2 3 4 5 Corp. A ($250,000) 56,250 61,500 67,163 73,262 79,822 Corp. B. ($250,000) 60,000 64,500 69,270 74,323 79,671

IRR A= IRR B =

10.30% 11.50%

After looking over the NPV of Corporation A and B it is clear that Corporation B has a higher present day value and its IRR is higher. Corporation B would be the best option to acquire. Even though both corporations have a positive NPV and they both have an IRR that is above the rate of discount Corporations B is still a better choice. It would be a better choice because its IRR is 0.5 over its discount rate where Corporation A is only 0.3 over its discount rate. In all there are a number of factors that can be taking into consideration when thinking about acquiring new things. It is important to know what is going to be important to you and your business and focus on those results in order to make an informed decision. It is always worth the extra time to conduct these type of precast and analysis before investing money. References Keown, A., Martin, J. D., & Petty, PhD, J. W. (2014). Foundation of Finance (8th ed.). Retrieved from The University of Phoenix eBook Collection database.

Capital Budgeting Case Study