Capital Expenditures Essay -- Finances Financial Corporations Essays

Capital Expenditures Capital expenditures have a significant impact on the financial performance of the firm; therefore, criteria for selecting projects must be evaluated with great care. Of the two corporations the firm is deciding to acquire, Corporation B is clearly the better investment as shown in Table 1 supported by the following data: net present value (NPV), internal rate of return (IRR), payback period, profitability index (PI), discounted payback period, and modified internal rate of return (MIRR) in addition to 5 year projections of income and cash flows. The 5 year projections of both Corporations A and B’s income statements and cash flows indicate that between the two corporations, Corporation B will maximize the firm’s value the most. This decision is further evidenced by the net present value obtained for both corporations. NPV is defined as the sum of the present values of the annual cash flows minus the initial investment. If the net present value (NPV) of all cash flows is positive, the project will be profitable. The NPVs for both corporations suggest that both projects are worthwhile, since each has a positive NPV, however, since the firm can only acquire one of the corporations, it must choose the acquisition of the corporation with a higher NPV – Corporation B. The Internal Rate of Return, IRR, is another business tool used for capital budgeting decision. IRR is the discount rate at which the present value of a series of investments is equal to the present value of the returns on those investments (NPV = 0). It is the compound return the firm will get from the project. IRR also takes into account the time value of money by considering the cash flows over the lifetime of a project. If IRR is greater than the discount rate, the firm may undertake the project in question. In this situation, acquisition of either corporation is worthwhile since each has an IRR greater than their respective discount rates, but since IRR gives the project’s compound rate of return, the project providing the higher compound rate of return should be selected which means that Corporation B is preferred to Corporation A. Both NPV and IRR analyses support the acquisition of Corporation B. In cases where a conflict exists between NPV and IRR as to which competing projects to choose, the project with the larger NPV should ... ..., the main concern should be on how the investment will affect the value of the firm’s stock more so than how long it takes to recover the investment that presupposes that the project does add value for stockholders. When using the payback period as a criterion for capital budgeting decision, it is better to use the discounted payback as it takes into account the time value of money although still inferior to NPV. In both projects, the initial cost is recovered even after discounting the cost of capital. In this situation, however, the difference in discounted payback period is negligible. In summary, after review of the 5 year projections of cash flows for both corporations and all other supporting data provided in this report, the firm should proceed with the acquisition of Corporation B. Had the firm have unequal projected years available to them for review, for instance, Corporation A had a 5 year projection of cash flows and Corporation B with a 7 year projection of cash flows, the decision outcome should be no different since analysis of NPV, IRR, MIRR, PI, payback period and discounted payback period will be carried out for the respective cash flows.