Finance Assignment Example: Capital Budgeting

This example focuses on a common finance assignment topic: capital budgeting. Capital budgeting involves evaluating potential investment projects to determine if they are worth undertaking. It’s a crucial skill for financial managers who need to make informed decisions about resource allocation.

Scenario: Evaluating a New Machine

Imagine your company is considering purchasing a new machine that will increase production efficiency. The machine costs $200,000 upfront and is expected to generate annual cash inflows of $60,000 for the next five years. At the end of the five years, the machine is expected to have a salvage value of $20,000. The company’s required rate of return (or discount rate) is 10%.

Key Calculations and Concepts

Several methods can be used to evaluate this project. We’ll focus on Net Present Value (NPV) and Internal Rate of Return (IRR).

Net Present Value (NPV)

NPV calculates the present value of all future cash flows associated with the project, discounted at the required rate of return, and subtracts the initial investment. A positive NPV indicates that the project is expected to add value to the company and should be accepted. The formula is:

NPV = Σ [Cash Flow_t / (1 + r)^t] – Initial Investment

Where:

• Cash Flow_t = Cash flow in year t
• r = Discount rate
• t = Year

In our example:

NPV = [$60,000 / (1 + 0.10)¹] + [$60,000 / (1 + 0.10)²] + [$60,000 / (1 + 0.10)³] + [$60,000 / (1 + 0.10)⁴] + [($60,000 + $20,000) / (1 + 0.10)⁵] – $200,000

Calculating this, we find that the NPV is approximately $30,391. Since the NPV is positive, the project should be considered.

Internal Rate of Return (IRR)

IRR is the discount rate that makes the NPV of a project equal to zero. In other words, it’s the rate of return the project is expected to generate. A project is typically accepted if its IRR exceeds the company’s required rate of return.

Finding the IRR usually requires iteration or a financial calculator. In our example, the IRR is approximately 16.3%. Since 16.3% is greater than the required rate of return of 10%, the project should be considered.

Conclusion

Both NPV and IRR suggest that the new machine is a worthwhile investment. However, it’s important to note that these are just two of many factors to consider. A thorough analysis would also include sensitivity analysis (how changes in assumptions affect the results), scenario planning (evaluating different possible outcomes), and consideration of qualitative factors like strategic fit and competitive advantage.