Capital Expenditures

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.

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 ...

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..., 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.