Cash Flow Estimation and Capital Budgeting:Applying Various Capital Budgeting Methodologies


Cash Flow Estimation and Capital Budgeting-Bakers Hughes incorporated

Applying Various Capital Budgeting Methodologies

The objective of a firm is to maximize shareholder wealth.  The Net Present Value (NPV) method is one of the useful methods that help financial managers to maximize shareholders’ wealth.

Suppose Bakers Hughes Incorporated is considering a new project that will have an initial cash outflow of $125,000,000.  The project is expected to have the following cash inflows:

Year    Cash Flow ($)

1          2,000,000

2          3,500,000

3          13,500,000

4          89,750,000

5          115,000,000

6          120,000,000

If the project’s cost of capital (discount rate) is 12.5%, what is the project’s NPV? Should the project be accepted?  Why or why not?

You may use the following steps to calculate NPV:

  1. Calculate present value (PV) of cash inflow (CF)

PV of CF = CF1 / (1+r)^1 + CF2 / (1+r)^2 + CF3 / (1+r)^3 + CF4 / (1+r)^4 + CF5 / (1+r)^5 + CF6 / (1+r)^6

Where the CFs are the cash flows and r = the project’s discount rate.

  1. Calculate NPV

NPV = Total PV of CF – Initial cash outflow

or -Initial cash outflow + Total PV of CF

r = Discount rate (12.5%)

If you do not know how to use Excel or a financial calculator for these calculations, please use the present value tables.
Online Learning Center. (n.d.) Present and Future Value Tables. Retrieved from http://highered.mheducation.com/sites/0072994029/student_view0/present_and_future_value_tables.html

Also, consider reviewing http://www.tvmcalcs.com for financial calculator tutorials.

Besides NPV, there are other capital budgeting methodologies including the regular payback period, discounted payback period, profitability index (PI), internal rate of return (IRR), and modified internal rate of return (MIRR).  These methodologies don’t necessarily give the same accept/reject decisions as NPV.

If the firm has a requirement that projects are paid back within 3 years, would the project be accepted based off the regular payback period?  Why or why not?  Would the project be accepted based off the discounted payback period?  Why or why not?

What is the project’s internal rate of return (IRR)?  Based off IRR, should the project be accepted?  Why or why not? Recall the project’s cost of capital is 12.5%.  What is the project’s modified internal rate of return (MIRR)?  Based off MIRR, should the project be accepted?  Why or why not?

What are the advantages/disadvantages of NPV, regular payback, discounted payback, PI, IRR, and MIRR?  Present these advantages/disadvantages in a table.

Assignment Expectations

You are expected to:

  • Describe the purpose of the report and provide a conclusion. An introduction and a conclusion are important because many busy individuals in the business environment may only read the first and the last paragraph. If those paragraphs are not interesting, they never read the body of the paper.
  • Answer the Assignment question(s) clearly and provide necessary details.
  • Write clearly and correctly—that is, no poor sentence structure, no spelling and grammar mistakes, and no run-on sentences.
  • Provide citations to support your argument and references on a separate page. (All the sources that you listed in the references section must be cited in the paper.) Use APA format to provide citations and references.
  • Type and double-space the paper.

Whenever appropriate, please use Excel to show supporting computations in an appendix, present financial information in tables, and use the data computed to answer follow-up questions.  In finance, in addition to being able to write well, it’s important to present information in a professional manner and to analyze financial information.

 

Cash Flow Estimation and Capital Budgeting

Capital Budgeting Podcast (2014).  Pearson Learning Solutions, New York, NY.

Capital Budgeting Interactive Video. (2014).  Pearson Learning Solutions, New York,

As a financial manager, you are to focus on maximizing shareholder wealth.  You do that by accepting positive NPV projects and rejecting negative NPV projects.  In order to run a NPV calculation, you need cash flows which need to be estimated.

There are several steps to estimate a project’s cash flows.

First, some assumptions need to be made regarding how many units of the goods are to be sold and at what price per unit.  The tax rate will also need to be determined.

Second, depreciation needs to be calculated.  You need to decide which depreciation methodology you will use such as straight-line depreciation or MACRS.

Third, you need to calculate the salvage value on the property and/or equipment that is disposed of at the end of the project’s life.

Fourth, you can now proceed to put things together and estimate the project’s cash flows:

At Time 0 (today), you are likely to have the following cash outflows:

Building and/or equipment

Increase in net working capital

= total investment outlays (negative value)

At Time 1 through Time N (the end of the project’s life), you are likely to have the following cash flows each year:

Sales revenue (units sold x sales price)

– Variable costs (usually some percentage of the sales revenue)

– Fixed operating costs

– Depreciation

= EBIT (earnings before interest and taxes)

-Taxes on the operating income

= NOPAT (net operating profit after taxes)

+ Depreciation add-back

= Operating cash flow

Then at Time N (the end of the project’s life), you have terminal year cash flows likely consisting of the following:

+ Return of the net working capital

+ net salvage value

= Total terminal cash flows

The project cash flows can finally be determined by adding together for the appropriate year the total investment outlays, the operating cash flows, and the total terminal cash flows.

Now that you have the project cash flows, you can apply the various capital budgeting methodologies including net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), profitability index (PI), regular payback period, and the discounted payback period.

Many of these can be calculated with Excel.

=NPV calculates a project’s NPV in Excel.

=IRR calculates a project’s IRR in Excel.

=MIRR calculates a project’s MIRR in Excel

Review this video that focuses on NPV:

JohnFinance (2014). Net Present Value. Retrieved June 2014 from http://www.youtube.com/watch?v=GiNG9Va00fI

NPV is the best out of all the capital budgeting methodologies.  It takes into all of a project’s cash flows, it uses the time value of money, doesn’t have problems with non-normal cash flows like IRR can have when it can result in multiple IRRs, assumes reinvestment of the cash flows at the more conservative cost of capital instead of the higher less realistic IRR reinvestment rate assumption, gives consistent results with mutually exclusive and independent projects.

Optional Resources

Bookboon.com. (2008). Corporate Finance. Retrieved from http://bookboon.com/en/economics-and-finance-ebooks

Welch, Ivo. (2014). Corporate Finance (3rd Ed.). Chpts 4 and 12. Retrieved from http://book.ivo-welch.info/ed3/toc.html

 

 

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: