The Director Of Capital Budgeting For Big Sky Health Systems

The Director Of Capital Budgeting For Big Sky Health Systems Inc

146 The director of capital budgeting for Big Sky Health Systems Inc has estimated the following cash flows in thousands of dollars for a proposed new service: Year Expected Net Cash Flow 0 ($70) 1 $50 2 $20 The project’s cost of capital is 10%.

a. What is the project’s payback period?

b. What is the project’s NPV?

c. What is the project’s IRR?

d. What is the project’s MIRR?

Paper For Above instruction

The process of capital budgeting involves evaluating potential investment projects to determine their financial viability. This analysis includes calculating key metrics such as payback period, net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR). These measures help decision-makers understand the profitability and risk associated with projects, enabling informed investment choices.

Part A: Calculating the Payback Period

The payback period indicates how long it takes for a project to recover its initial investment through cash inflows. For the proposed project at Big Sky Health Systems Inc., the initial outflow is $70,000, with subsequent inflows of $50,000 in year 1 and $20,000 in year 2.

Cumulative cash flows:

  • Year 0: -$70,000
  • Year 1: -$20,000 (since -$70,000 + $50,000 = -$20,000)
  • Year 2: $0 (since -$20,000 + $20,000 = $0)

The initial investment is recovered during Year 2. To find the exact payback period, we determine how much of Year 2’s cash flow is needed to fully recover the remaining $20,000 after Year 1. Since the cash flow in Year 2 is $20,000, the payback period is 2 years.

Part B: Calculating the Net Present Value (NPV)

The NPV formula is:

NPV = ∑ (Cash Flow in Year t) / (1 + r)^t

where r = 10% or 0.10.

Adding the discounted cash flows:

  • Year 0: -$70,000 (initial investment, not discounted)
  • Year 1: $50,000 / (1.10)^1 ≈ $45,454.55
  • Year 2: $20,000 / (1.10)^2 ≈ $16,529.75

Calculating NPV:

NPV = -$70,000 + $45,454.55 + $16,529.75 ≈ -$8,015.70

The negative NPV suggests that at a 10% discount rate, the project would diminish value by approximately $8,015.70, indicating it may not be financially attractive under these assumptions.

Part C: Calculating the Internal Rate of Return (IRR)

The IRR is the discount rate that makes the NPV zero:

0 = -$70,000 + $50,000 / (1 + IRR)^1 + $20,000 / (1 + IRR)^2

This equation can be solved iteratively or using financial software like Excel’s IRR function. Using Excel, inputting cash flows (-70, 50, 20) and applying the IRR function yields approximately 7.5%. Since the IRR is below the cost of capital (10%), the project would not meet the required return threshold.

Part D: Calculating the Modified Internal Rate of Return (MIRR)

The MIRR considers the cost of financing and reinvestment rates, providing a more realistic profitability measure.

Assuming the reinvestment rate and finance rate are both 10%, the MIRR is calculated as:

MIRR = (FV of positive cash flows / PV of negative cash flows)^(1/n) - 1

FV of positive cash flows (reinvested at 10%):

  • Year 1 cash flow: $50,000 compounded for 1 year: $50,000 × 1.10 = $55,000
  • Year 2 cash flow: $20,000 compounded for 0 years: $20,000

Total future value (FV): $55,000 + $20,000 = $75,000

The present value (PV) of the initial investment is $70,000.

Calculate MIRR:

MIRR = (75,000 / 70,000)^(1/2) - 1 ≈ (1.0714)^(0.5) - 1 ≈ 1.0357 - 1 ≈ 3.57%

This indicates a MIRR of approximately 3.57%, which is below the project’s required return of 10%, thus reinforcing the project’s lack of profitability under these assumptions.

Summary and Conclusion

The investment’s payback period of 2 years suggests quick recovery of initial investments. However, the NPV is negative, and both IRR and MIRR are below the cost of capital, indicating that the project does not add value for Big Sky Health Systems Inc. decision-makers should therefore be cautious and consider alternative investments with better returns.

Additional Notes on Using Excel for These Calculations

All above calculations can be efficiently performed using Microsoft Excel. For example, entering the cash flows into cells and applying functions such as =NPV(), =IRR(), and custom formulas for MIRR can streamline the process, especially when dealing with multiple projects or more complex cash flow patterns. Excel’s built-in functions help ensure accuracy and expedite decision-making, which is vital when data is needed promptly, such as by 5:00 pm Alaska time.

References

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