Capital Budgeting: Net Present Value vs Internal Rate of Return (Relevant to AAT Examination Paper 4 – Business Economics and Financial Mathematics) Y O Lam
Capital budgeting assists decision makers in a company evaluate multiple investments of the company’s capital. Capital budgeting is used to plan for the acquisitions of other companies, for the development of new product lines of business, for the expansion of the existing production plants or for the replacement worn-out equipment, and in planning decisions on whether or not to enter a new market line, whether to buy or rent production facilities, and any other investment project resulting in costs and revenues that are spread over a number of years. Capital budgeting is the method used to assess a major investment or to see whether one option is better than another. There are several capital budgeting methods, each with advantages and disadvantages. In this article, we discuss the basic principle and the advantages and disadvantages of using the net present value technique and the internal rate of return technique.
Net present value (NPV) method
When using the net present value method of capital budgeting, one of most important factors is the estimation of net cash flows from an investment. The net cash flow is the difference between cash outflows and cash inflows over the life of the investment. First, cash flows should be calculated on an incremental basis, and include changes in operating cash flows and changes in investment cash flows. Second, cash flows must be measured on an after-tax basis. Third, non-cash expenses are also considered; for example, depreciation is an expense item but not a cash flow.
NP Ltd is considering an initial investment of $100,000 in order to open a new production line for a new product. The expected life of the production line is four years. Sales are estimated to be $100,000 during the first year and to increase by 10% per year until the fourth year. The variable costs of the producing the product are 50% of sales and the additional fixed costs are $15,000 per year. The simplified straight-line depreciation method is used to calculate depreciation. NP Ltd requires an after-tax return of 40% and also expects to recover $10,000 of its working capital at the end of the fourth year.
The following gives the detailed information on the new product line: New product
Annual operating costs
Variable costs in the first year
Sales during the first year
The estimated cash flow from this investment are summarized as follows: Estimated cash flow
Net cash flow
Less: Variable costs
Profit before tax
Less: Income tax
Profit after tax
Recovery of working capital
Net cash flow in year 4
We need to assign a discount rate to evaluate each of the competing alternatives for a firm’s capital to decide whether or not a firm should undertake an investment. The discount rate is estimated using the cost of capital of the investment to the firm. Net present value capital budgeting gives us the present value of the expected net cash flows from the investment, discounted at the firm’s cost of capital, minus the investment of capital needed today.
For example, if NP Ltd expects a cost of capital of 12%, the net present value of the investment can be seen above, and the initial investment is $100,000, then the net present value of the new production line is:...