Valuing the Capital Investment Projects

CAPITAL INVESTMENT PROJECTS’ VALUING 5

Valuing the Capital InvestmentProjectsNameInstitutionDateValuing the CapitalInvestment Projects

Case Study Company: Growth Enterprises, Inc (GEI)

The valuation of any project requires proper determination of thecash flows to enhance determination and implementation of capitalbudgeting. Currently, Growth Enterprises Inc is considering fourprojects, with a cost of investment of $10,000 each. Each project haddifferent cash flows. The depreciation years valid from one projectto the other in A, a depreciation of 1 year was used, 2 years forproject B and three years for Projects D and C. This was done on aline basis and the results presented in the Table 1 below.

Table 1: GEI’s Cash Flows

Project

Type of cash flow

Year 0

Year 1

Year 2

Year 3

Payback Period

IRR

NPV

(10% WACC)

NPV

(35% WACC)

A

Investment

-$10,000

0

0

0

1

0%

-$1,229,980

-$2,592,590

Revenue

0

$21,000

0

0

Operating expense

0

$11,000

0

0

B

Investment

-$10,000

0

0

0

1.33

32%

$3,016,880

-$328,960

Revenue

0

$15,000

$17,000

0

Operating expense

0

$5,833

$7,833

0

C

Investment

-$10,000

0

0

0

2.1

34%

$5,281,910

-$229,010

Revenue

0

$10,000

$11,000

$30,000

Operating expense

0

$5,555

$4,889

$15,555

D

Investment

-$10,000

0

0

0

1

43%

$4,650,990

$821,780

Revenue

0

$30,000

$10,000

$5,000

Operating expense

0

$15,555

$5,555

$2,222

Payback Period

The calculation of the payback period outlines how long each projecttook to recover the initial invested amount. Project A had a paybackperiod of 1 year, project B 1.33years, Project C 2.1years and projectD one year.

IRR

The formula used in calculating the IRR, Project A had an IRR valueof 0%, B was 32%, C had 34% and D had 43%.

NPV

  • A WACC of 10% and 35% was used to calculate the NPV. Using a 10% WACC, Project A had an NPV value of -$1,229,980, B was $3,016,880, C gave $5,281,910 while D was $4,650,990

  • Using a 35% WACC, had had an NPV of -$2,592,590, B was -$328,960, C gave -$229,010, while D was $821,780.

Ranking

Ranking each project using capital budgeting criteria, a cleardifference in ranking can be observed.

  • For instance, based on payback period, A will be the best because the investment is recovered immediately after one year. Despite D having a similar payback period, the FCF for D during the first year is higher by $200, hence hold the second position, B is the third (1.33years), and C (2.1years) is the last.

  • Based on IRR, D can be considered to be the best project, C the second, B the third and A the worst.

  • Based on NPV with a WACC of 10%, the best project would be C, then D, B and finally A.

  • Using a WACC of 35%, the D would be ranked the best, then C, B the third best and A the worst.

It can, therefore, be concluded that rankings tend to differ fordifferent methods of capital budgeting. This is majorly because eachmethod is calculated using a different formula. Payback periodprovides an estimate of the time taken by a project to recover theinitial invested capital. The methods seem easy to calculate andunderstand. Payback period is a good method when analyzing thecapital budget requirements. On the other hand, IRR reflects the rateof return on a particular project and takes into account all the FCFfrom the onset of the project when t=0. The NPV is critical indetermining the total present value for all the FCFs of a project.Normally, NPV makes use of weighted average cost of capital (WACC) asthe discount rate in order to discount all the FCFs that areassociated with that particular project.

If the projects can be considered to be independent of each other,then the choice of more than one project for funding is possible.When 10% WACC is used to calculate NPV, then the projects that shouldbe selected are B, C and D. This selection also applies if the IRRis to be used. On the other hand, when using the 35% WACC incalculating the NPV, only Project D can be selected because it is theonly one having a positive NPV.

If the projects are to be considered as mutually exclusive, thenusing a WACC of 10%, then the best project would be C since it hasthe highest NPV value. It is important to note that despite D havinga higher NPV than C, the selection of C is because project withhigher NPV is better because it gives the value rather thanpercentage, hence a more accurate determinant of the value of theproject. When using a WACC of 35%, then the mutual exclusive selectedproject would be D as it is the only one having a positive NPV.

It can be deduced from the analysis that increasing WACC from 10% to35% results in a corresponding changes in NPV value. For instance,for project A, the value at 10% is negative, and increasing the WACCto 35% makes the NPV value become more negative. Similarly, as WACCincreased from 10% to 35%, the NPV values for projects B and Cchanged from positive to negative. Only project D maintained apositive value as WACC increased to 35% though the value becameconsiderably smaller as the WACC increased.

It can be perceived that the use of 10% WACC allowed severalalternative projects that were attractive but when 35% WACC was used,the projects became dramatically unattractive. The decision regardingthe most appropriate project varied drastically as the WACC increasedand was affected irrespective of whether the projects were to becarried out independently or in a mutual exclusive manner.