Capital Budgeting Decisions At Chee Company

Capital Budgeting Decisionschee Company Has Gathered The Following Dat

Chee Company has gathered the following data on a proposed investment project: investment required in equipment of $240,000, annual cash inflows of $50,000, salvage value of $0, life of the investment of 8 years, and a required rate of return of 10%. Assets will be depreciated using the straight-line depreciation method. The task is to evaluate whether this is a good investment using the net present value (NPV) and the internal rate of return (IRR) methods.

Paper For Above instruction

Assessing the viability of investment projects is a fundamental aspect of capital budgeting, enabling companies to allocate resources effectively and maximize shareholder value. In this context, Chee Company’s proposed project requires a detailed financial evaluation using two of the most widely used capital budgeting techniques: the net present value (NPV) method and the internal rate of return (IRR) method.

Understanding the Project Data

The project entails an initial capital expenditure of $240,000 for equipment, expected to generate annual cash inflows of $50,000 over 8 years. The auction value at the end of the project’s life is $0, indicating no residual value. Given the straight-line depreciation method, the annual depreciation expense will be calculated as:

Depreciation Expense = Total Equipment Cost / Useful Life = $240,000 / 8 = $30,000 per year.

While depreciation affects accounting income, cash flows are what primarily influence investment decisions. Therefore, the cash inflows are considered $50,000 annually. The company's required rate of return for this investment is 10%, which will serve as the discount rate for the NPV calculation and as a basis for IRR interpretation.

Calculating Net Present Value (NPV)

The NPV method involves discounting all future cash inflows to their present value and subtracting the initial investment. For this standard project, assuming cash inflows remain consistent over 8 years, the NPV is calculated as:

NPV = (Sum of Present Value of Cash Inflows) - Initial Investment

Using the Present Value of an annuity formula:

PV of an annuity = CF × [(1 - (1 + r)^-n) / r]

where CF is the annual cash inflow of $50,000, r is the discount rate of 10%, and n is 8 years.

Calculating the present value factor:

PV factor = (1 - (1 + 0.10)^-8) / 0.10 ≈ 5.3349

Thus, the present value of inflows:

PV of inflows = $50,000 × 5.3349 ≈ $266,745

Calculating NPV:

NPV = $266,745 - $240,000 = $26,745

Since the NPV is positive ($26,745), the project is expected to generate more cash than the required return, indicating it is a financially viable investment.

Calculating Internal Rate of Return (IRR)

The IRR is the discount rate that makes the NPV of the project zero. It is found by solving the cash flow equation where the present value of inflows equals the initial investment:

$240,000 = $50,000 × [(1 - (1 + IRR)^-8) / IRR]

Solving for IRR generally requires iterative methods or financial calculator/software. Using approximate methods or financial software, the IRR can be found by trial and error or interpolation.

Estimate IRR:

Trying a rate of 12%:

PV factor at 12% = (1 - (1 + 0.12)^-8) / 0.12 ≈ 4.9674

PV of inflows at 12% = $50,000 × 4.9674 ≈ $248,370

This exceeds the initial investment of $240,000, indicating IRR > 12%. Trying a higher rate, say 14%:

PV factor at 14% ≈ (1 - (1 + 0.14)^-8) / 0.14 ≈ 4.2922

PV of inflows = $50,000 × 4.2922 ≈ $214,610

This is less than $240,000, so IRR is between 12% and 14%. Interpolating between 12% and 14%:

IRR ≈ 12% + [(240,000 - 248,370) / (248,370 - 214,610)] × (14% - 12%) ≈ 12% + [(-8,370) / (33,760)] × 2% ≈ 12% - 0.495 × 2% ≈ approximately 11.01%

Refining further, the IRR is approximately 12%, corroborating the previous estimate.

Since the IRR exceeds the required rate of return of 10%, the project is deemed acceptable based on IRR criteria as well.

Conclusion

Both the NPV and IRR methods suggest that the proposed investment project is financially viable. The positive NPV of approximately $26,745 indicates that the project would add value to Chee Company beyond the cost of capital, and the IRR estimate of about 12% exceeds the company's required return of 10%. Therefore, based on these capital budgeting analyses, the project should be considered a good investment opportunity. However, it is also prudent to consider other qualitative factors and potential risks before making a final decision.

References

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