Capital Budgeting Case
It is important for an organization to analyze and compare projected cash flows in determining whether or not an investment should be made. In order to do so, the analyst will need to compile information on about the project then interpret that information. When only one investment may be made, but there is an opportunity to purchase multiple investments then the analyst will have to compare the investments against each other to make a suggestion for management.
The first step in completing a capital budget analysis is to forecast each project’s future value. The goal is to determine if the project is worth investing in. This is done with comparison of cash flows, the evaluation of NPV and IRR to determine the projects value. The NPV will help determine if the project is a good investment for the firm.
Net Present Value (NPV)
According to Investopedia.co (2014), “net present value compares is the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if the NPV is negative, the project should probably be rejected because cash flows will also be negative” (para. 3). Thus, NPV analysis is used to determine the reliability of future cash flows of a project.
An easy and quick example of using NPV to determine the value of a project is the purchase of a business. In crunching the numbers if the business NPV is more than the cost of the purchase then the sale should be completed. On the reverse side, if the NPV is lower than the cost of the business the sale should not be completed because the value of the business is too low.
Internal Rate of Return (IRR)
The internal rate of return is the “rate of growth a project is expected to generate” (Investopedia.com, 2014, para2). Thus, a project with a higher IRR will most likely provide a better chance of financial growth than one with a lower...