Finance

Name
Instructor
Course
Date
Capital Budgeting in Corporate Finance
Question 1
Before a company commits shareholders’ funds into an investment project, due diligence must be done as a way of making sure that the investment meets specific criteria. One of the main invest criteria used includes the use of the net present value, internal rate of return, the profitability index and the discounted payback period.
Question 1(a)
The net present value involves the discounting of all the cash flows related to the project (Brealey 99). This includes both positive and negative cash flows. This is one of the main project evaluation criteria. Project A has a cost of capital of 9%, and its cash flows are as follows.
Year Cash flow Discount rate Discounted amount NPV At time o
0 -8,000 1 -8,000 1390.001
1 1,500 0.917431 1376.147 2 2,000 0.84168 1683.36 3 2,500 0.772183 1930.459 4 3,000 0.708425 2125.276 5 3,500 0.649931 2274.76 As shown in the figure above, the net present value for Project A is USD 1390.001.
The Profitability index shows the relationship that exists between the cost and benefits of a project. We find it by dividing the net present value of the future cash flows by the initial project fund. If the profitability index is more than one, then we should invest in the project as it is more attractive. The net present value of the future cash flows of our project is USD 9,390.001(1376.147+1,683.36+1,930.459+2,125.276+2,274.76). The profitability index of project A is thus 1.1737 (9,390.

001/8,000).
Project B has used an initial cost of USD 9,500, and its cost of capital is at 10%. We, therefore, calculate the net present value of its cash flows as follows.
Year Cash flow Discount rate (10%) Discounted amount NPV At time o
0 -9,500 1 -9,500 3,407.87
1 2,500 0.909091 2,272.73 2 3,000 0.826446 2,479.34 3 3,500 0.751315 2,629.60 4 4,000 0.683013 2,732.05 5 4,500 0.620921 2,794.15 From our calculation, project B has a net present value of USD 3,407.87. Also, its profitability index is found by dividing the future discounted cash flows by the initial investment. This will thus give 1.358723 (12,907.87/ 9,500). From this analysis, we find the project B has a net present value of USD 3,407.87 while that one for project A is USD 3,407.87. Also, project B has a profitability index of 1.358723 while the profitability index for project A is 1.1737. It will thus be prudent to invest in project B as it will increase investors’ wealth considerable.
Question 1(b)
The payback refers to the period it takes for an investment to return the initial funds used to set it up. The payback period is thus crucial as a project with a shorter payback period will be more attractive. This method disregards the time value of money. For project A, we will take the number of years it takes to reach the USD 8,000. For three years, USD 6,000 will have been returned. For the third year, we will take USD 2,000 divide by USD 3,000. Hence the payback period will be 3.666 years. For Project B, it takes three years to get to USD 8,000.
Furthermore, it takes an additional 0.0625 years to reach USD 9,500. The last part of the year is found by dividing USD 500 by USD 8,000. Hence it is 3.0625. Therefore, project B has a shorter payback period, and thus it will be prudent to invest in it.
Question 1(C)
The discounted payback period is one of the capital budgeting criteria that is used in knowing when a project will break even (Brealey 110). This implies merely the time it takes for a plan to get out of the red zone. When we add the first four discounted future cash flows for project A, it totals to USD 7,115. This implies that the discounted payback period is between times 4 to 5. For project B, adding the first four discounted cash flows results to a value of USD 10,113. This clearly shows that the discounted payback period is between time 3 and four. As a result, the discounted payback period for project B is shorter than that one for project A. Therefore; an investor will recoup his investment within a shorter period if he invests in project B compared to A. Hence, project B is more attractive as an investment.
Question 1(D)
The net present value is significant when it comes to capital budgeting decisions. It is one of the essential criteria applied when choosing mutually exclusive and independent projects. A fund manager should a plan with a higher net present value as compared to one with a lower NPV. A project with a higher NPV is guaranteed to increase the investor’s wealth considerably (Brealey 101).
The NPV and IRR are essential criteria in capital budgeting decisions. Two similar projects might have one with a higher NPV and lower IRR while the other one with a lower NPV and higher IRR. The IRR is typically used by firms in meeting the hurdle rate. The NPV should be deployed in the event these two have conflicting results. The NPV shows the projects that can grow wealth considerably, while the IRR does not.
Question 2
The income statement and the balance sheet give a snapshot of the company’s assets and liabilities. Also, the income statement will show how the revenue, expenses and the profits have grown from year to year. In our case, we take a look at Delta airlines. In 2016, the company had gross revenue of USD 39 billion while in 2017, the gross revenue was USD 41 billion. However, the same year witnessed an increase in cost from USD 159.9 billion in 2016 to USD 17.3 in 2017. This saw a dip in profit from USD 4.37 to USD 3.57 billion 5 (National Association of Securities Dealers Automated Quotations). This decrease can be attributed to poor economic conditions. A look at the current assets shows that the company increased it from USD 15 billion to USD 18 billion. This is an indication that the company is in good in financial position. The depreciation expense for the company was USD 12,456 million in 2016 and USD 14,097 in 2017 5 (National Association of Securities Dealers Automated Quotations). This represent a percentage increase of 13.8% ((14,097-12,456)/12,456). The depreciation method used was the straight-line method, and the assets have depreciated by 13% illustrating an increase in the operational costs (National Association of Securities Dealers Automated Quotations).
In part related to cannibalization, we shall look into the situation related to Apple Inc. Apple is considered one of the technology giants of the 21st century. Apple is credited with the invention of many advanced some of which they have cannibalized themselves. For instance, the company stopped the production of the iPad after the iPhone cannibalized this market. In essence, Apple aims to fights cannibalization through innovation and seeks to be the pacesetter in the market. The company offers different product options to its consumers, and the CEO has even hinted the company will always cannibalize its products.
Work Cited
Brealey, Richard A., et al. Principles of corporate finance. Tata McGraw-Hill Education, 2012.
National Association of Securities Dealers Automated Quotations. (n.d.). Home Depot, Inc. (The) (HD) Stock Report – NASDAQ.com. Retrieved August 04, 2017, from http://www.nasdaq.com/symbol/hd/stock-report