...Return on Equity (ROE) and Internal Rate of Return (IRR) are two very important tools which can be used in decision making in expanding and investing in overseas projects. Return on Equity (ROE) tells how much profit company is generating with shareholder's money. ROE is calculated as: ROE = Net Income/Shareholder's equity This net income is income after paying tax and preferred stock dividend but before paying common stock dividend.ROE measures profit generating efficiency of the company. (McClure, 2010) Higher the ROE, better the investment opportunity company is offering. Advantage of using ROE for investment decision is, it is easy to calculate and it tells how much profit company is generating for share holders. Ultimate goal of a company is to create value for shareholders. Thus, ROE is the right measure to find out if company is efficient in generating profit on its equity (and asset) or not. However, ROE is not the absolute indicator of investment value. If value of shareholder's equity falls, ROE will go up. Similarly, if company is taking large write-down, ROE will fall sharply. Share buyback also lowers ROE while there is no change in company's operation. (McClure, 2010) Internal Rate of Return (IRR) is an indicator of yield of an investment.IRR is widely used method in capital budgeting decisions. IRR is the discount rate where total present value of all cash inflows is equal to total present value of all cash outflows. i.e. IRR is the discount rate at which...
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...An organization’s valuation can create very efficient planning and capital distribution making this an important step in the organization’s valuation. The short and long term investments of an organization affect the day to day decisions of management and it also affects the organization’s value. Because this affects the value of the organization it becomes extremely important to use appropriate and precise valuation methods in order to estimate business activities and or projects that can affect the value. Using valuation methods such as Internal Rate of Return or the Modified Internal Rate of Return can eliminate improper decisions and the organization will be able to manage their assets and capital in a successful manner and meet the goals of the organization. An organization’s valuation determines what it is worth or what an asset is worth. An organization that has a low value has not made good business decisions, where as an organization that has high value has made good business decisions. Organizations with high value have structured capital with goals in mind. This also allows the organization to have more opportunities for projects and or investments which can increase the value of the organization. Cash flow is a very important especially to have a high and strong cash flow because this helps the organization build value. Poor cash flow can restrict organizations from new projects and handling their debt to creditors properly. If the poor cash flow were to continue...
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...project's liquidity and risk. 3. The internal rate of return is that discount rate which equates the present value of the cash outflows (or costs) with the present value of the cash inflows. 4. Under certain conditions, a particular project may have more than one IRR. One condition under which this situation can occur is if, in addition to the initial investment at time = 0, a negative cash flow occurs at the end of the project's life. 5. Conflicts between two mutually exclusive projects, where the NPV method chooses one project but the IRR method chooses the other, should generally be resolved in favor of the project with the higher NPV. 6. A capital budgeting project is acceptable if the rate of return required for such a project is greater than the project's internal rate of return. 7. Any capital budgeting investment rule should depend solely on forecasted cash flows and the opportunity rate of return. The rule itself should not be affected by managers' tastes, the choice of accounting method, or the profitability of other independent projects. 8. The main reason that the NPV method is regarded as being conceptually superior to IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist. 9. Effective capital budgeting can improve the timing of asset acquisition and the quality of assets purchased, thereby providing an opportunity to purchase and install assets before they are needed. 10. An increase in the discount rate used in computing the NPV of a...
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...increase their offerings, decrease their cost and possibility find new funding sources to achieve its goals of the company. The payback period is the length of time that is required for Guillermo Furniture to cover the initial investment for the proposed project. The payback period determines how many periods it will take for Guillermo to return the initial investment. In using the payback period when having multiple projects to chose from the one with the shortest payback would be considered a good choice. Calculation of the payback period is summing the project's positive cash flows per period, typically annually, until the sum equals the project's initial investment (www.associatedcontent.com, 2009). The number of time periods passed before inflows are equivalent to original investment price represents the payback period (www.associatedcontent.com, 2009). Net present value method picks up where the payback period lacks because net present value provides a gauge for profitability and also takes in account the time value of money. The difference between the market value and the post of the project is the NPV, and the realization that interest rates and inflation will impact this value over time is the principle behind the discounted cash flow valuation technique used in figuring the net present value (www.associatedcontent.com, 2009). The net present...
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...Company A Source of Capital Percent of total Rate of return Bonds 40% 6.2% Preferred Stocks 10% 8% Common Stocks 50% 12.4% Total: 100% Task A: Calculation of Weighted Average Cost of Capital (WACC) Formula for WACC = [D/V(1-Tc)Rd] + (E/V x Rc) + (E/V x Rp) Where: D/V = percentage of financing that is debt E/V = percentage of financing that is equity Tc = Corp. Tax Rate Rd = return on debt Rc = return on common stock (equity) Rp = return on preferred stock (equity) Computation: WACC = (.40 x .062) + (.50 x .124) + (.10 x .08) = .0248 + .062 + .008 WACC = .0948 or 9.48% This means that it will cost the Company A 9.48% for every $100 raised through debt & equity, base on the given weight. This is also represented the minimum rate of return after tax that Company must earn on this project in order to provide a fair return to its investors. Task B1: Explanation of how cost of capital is used in net present value analysis Before deciding whether or not to invest money into a project that generates a certain rate of return or a certain amount of money (cash inflow or cost of capital), investor or management would like to first estimate the future rate of return (future cash flow) and then discount it to today’s rate/value (present value). The difference between these present rates of return or cash flows is called net present value. The...
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...determined that the company would save $72,540 per year in cash savings, as well as $32,000 in tax savings as a result of depreciation, if the company manufactures the cans instead of buying them. The total annual cash flow generated after considering taxes would add up to $ 58,351. The equipment would pay for itself in 3.4 years while increasing income as result of the decreased cost with an annual rate of return of 13.18%. The Net Present Value was calculated at $33,035. Annual cash flow generated within the 5 years would result in an Internal Rate of Return of 18%. Calculations Summary: Annual cash flows over the expected life of the equipment = $ 58,351 Payback period = 3.4 Years Annual rate of return = 13.18% Net present value = $ 33,035 Internal rate of return = 18.0% This proposal should be accepted because of the significant reduction in cost, the attractive positive Net Present Value and the high Internal Rate of Return. The Positive NPV indicates positive future cash flows and present equity. The high Internal Rate of Return indicates an increased rate of future growth as a result of the reduced cost and increased cash...
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...choose from 3 different options. He could shift to the high-tech solution, become a representative for another manufacturer, or continue in the market he currently is in. Over the next couple of pages I will look into the different capital budget techniques available, explain how the techniques would help, and make a recommendation on a route Guillermo Furniture should go in to continue to thrive in the ever changing surroundings. Capital Budget Techniques “Managers can choose from among numerous analytical techniques to help them make capital investment decisions. Each technique has advantages and disadvantages” (Edmonds, 2007). The three techniques that we will focus on are the payback method, net present value (NPV), and the internal rate of return (IRR). First there is the payback method. This is pretty simple to figure out and understand. This is how long it will take a business to recover the initial outflow for an investment. Payback period = Net cost of investment/Annual net cash inflow “Generally, investments with shorter payback periods are considered better. Because the payback method measures only investment recovery, not...
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...policies. The capital budget process in the public sector explores a variety of objectives to determine the best financial impact for the federal, state, and local government entities. The process chooses capital projects from a number of potential options based on several factors such as payback periods, internal rate of return, and the net present value for each project. Each factor should work together effectively to ensure the greatest return in the least amount of time. This paper will focus on determining the best financial outcome for a capital budget using these methods and calculations. To gain an understanding of the capital budget process, Project A and B will be analyzed to determine which project is best for a city council. The calculations will also help to justify each project and if both can be used simultaneously. 2 CRUNCHING NUMBERS Payback Period (Project A and B) The period for payback is the technique which is used measure the length of time that a project recoups the initial investment of the firm. Following the technique, the profits before depreciation (cash flow) is the amount of time required to repay an investment, while accumulating investment returns (Morrell, 2007). The shorter payback period is preferred because the investment costs are paid earlier allowing available funds for future use, in addition to less risk factor. According to Mikesell (2010) the shorter the payback period, the more attractive the project will appear to the firm (Fiscal...
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...company based in Norway and becoming a broker. Before proceeding, Guillermo will have to differentiate between the various capital budget evaluation techniques. Capital budgeting is a budgeting technique that is used to make various intermediate range decisions. In the Guillermo Furniture example, capital budgeting will help Guillermo to determine whether to purchase or lease the new hi-tech manufacturing equipment or whether Guillermo should increase his sales through changing his business model into a brokerage. There are several capital budgeting techniques that Guillermo can use to determine how best to proceed with his decisions. These concepts include the net present value, internal rate of return, the simple and discounted payback method, the unadjusted rate of return and the annual rate of return method (it is important to note that there are various other capital budgeting techniques). It is important to remember that each of these techniques has their own advantages as well as disadvantages. Also, more than one technique can be applied to a particular proposal to take advantage of more information. To help Guillermo determine the profitability of the investment, he could use the net present value method. The net present value is the difference between the present value of cash inflows and the...
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...Budgeting Model Case Paper February 24, 2014 When incorporating whether to purchase Corporation A or Corporation B, it was easy to choose Corporation B. The reason behind this decision is based on a multitude of things. The income statements are close to one another, and even though the statement is slightly greater in Corporation A than B, that is not the main reason for the decision. The income statement is very similar to a company’s cash flow. With the income statement being marginally greater with company A the cash flow of company B is much greater. Unlike the difference of just under $200 with the net income, the cash flow is greater by more than $3,500 between the two corporations. Cash flow can be defined as “A revenue or expense stream that changes a cash account over a given period ("Excess Cash Flow", 2014).” This is significant when deciding on what business to take in. Having more money on hand will allow for that company to put that money back into the business. This makes the company expand, and become more profitable. Having this extra cash can also mean that everyone will be able to paid in a timely manner, and the company being less likely to go bankrupt. That $3,500 difference can add up over time. When it comes to net income, the figures say that the company A can make more money than company B, but the cash flow is where we can see the biggest gain. The next item is the NPV, net profit revenue, this is a much bigger decision maker...
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...Running head: Portfolio Project- Capital Budgeting Page 1 Capital Budgeting April Sutton July 12, 2013 FINANCIAL MANAGEMENT 3004 Instructor Nickey Turner Walden University Running head: Portfolio Project-Capital Budgeting Page 2 INTRODUCTION Capital Budgeting is defined as the process of planning and managing a firm’s long-term investments (Ross, Westerfield & Jordan. 2013). The question of what long term investment should be made is the first step of answering this question. The issues that arise with the asking of this question will be detailed in this paper. Capital Budgeting techniques include the Payback Rule, IRR, NPV, and the Profitability Index. PAYBACK RULE The payback method indicates that an investment is acceptable if its calculated payback is less than some prescribed number of years. The payback method does not consider the present value of cash flows. Under this method, an investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it (www.accountingformanagement.org).The payback period of a project is expressed in years and is computed using the following formula: Formula of payback period: According to this method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project computed by the above formula is shorter than or equal to the management’s...
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...Table of Contents Definition of capital budgeting 2 The Major Capital Budgeting Techniques 4 Payback Period 4 Internal Rate of Return 7 Factors Influencing Capital Budgeting 7 Need For Capital Budgeting 7 Capital budgeting project 8 References 9 Definition of capital budgeting Capital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). Planning the eventual returns on investments in machinery, real estate and new technology are all examples of capital budgeting. Management must allocate the firm's limited resources between competing opportunities (projects), which is one of the main focuses of capital budgeting. Capital budgeting is also concerned with the setting of criteria about which projects should receive investment funding to increase the value of the firm, and whether to finance that investment with equity or debt capital. Investments should be made on the basis of value-added to the future of the corporation. Capital budgeting projects may include a wide variety of different types of investments, including but not limited to, expansion policies, or mergers and acquisitions. When no such value can be added through the capital budgeting process and excess cash surplus exists...
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...Guillermo Furniture Store Analysis FIN/571 Guillermo Furniture Store Analysis Kirk B. Carlson FIN/571 Guillermo Furniture Store Analysis Guillermo Furniture Store is located in Senora, Mexico. Guillermo Navallez is the owner and has been successful in business for many years. He manufactures mid quality to high quality furniture at reasonable prices. New competitors have entered Senora, Mexico and are competing for Guillermo Navallez’s customers. As a result of the increase in competition Guillermo Furniture Store’s profit margins have been decreasing. This has forced Guillermo Navallez to re-evaluate his business and make adjustments to stay competitive. Guillermo Navallez needs to weigh his options and pick the best solution for his business. This paper will outline the cost of capital associated with the optimal weighted average, and valuation techniques that can be used by Guillermo Navallez to reduce risk. Options Guillermo Navallez goal is to become a profitable organization and to become a profitable organization he has three options that he needs to consider. The first option is to covert his facility into a high technological facility with the latest manufacturing technology. Guillermo Navallez’s initial cost for the equipment will be high, and he will have to weigh the cost of equipment with the benefits that the equipment will bring to the organization over time. Guillermo Navallez second option is to become a broker for another manufacturing company...
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...future. This amount includes inflation and returns. This method is likely the most correct budgeting method that business owners can use in the decision making regarding new capital projects. If the NPV of a project is positive, then it will be accepted. If the project is negative, then it will be rejected. 2. What is the payback period statistic? What is the acceptance benchmark when using the payback period statistic? The payback period statistic is the length of time required to recover the cost of an investment. The payback period of a capital project is an important determining factor of whether or not to partake in the project. It is calculated as payback period = cost of project / annual cash inflows. 3. Describe the Internal Rate of Return (IRR) method for determining a capital budgeting project's desirability. What is the acceptance benchmark when using IRR? The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR). In the context of savings and loans the IRR is also called the effective interest rate. the IRR of an investment is the interest rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment. Internal rates of return are commonly used to evaluate the desirability...
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... * Payback reciprocal * Payback bail-out period * Accounting rate of return Discounted cash flow methods * Net present value * Present value index (profitability index) * Annualized net present value or Equivalent annual annuity * Present value/discounted payback * Internal rate of return * Modified internal rate of return Methods that consider risk * Breakeven Cash Inflow * Risk-Adjusted Discount Rates * Certainty Equivalents * Simulation * Sensitivity and Scenario Analysis * Probability Trees I. Non-discounted cash flow techniques: A. Payback period (payoff/payout period) – measures the length of time required to recover the initial investment Decision rule: Accept if payback < required maximum payback Reject if payback > required maximum payback 1. Even cash flows Payback Period = Net Investment Annual CFAT 2. Uneven cash flows Payback Period = point where the cumulative cash flows equal the net investment Advantages: 1. easy to compute and understand 2. used to measure degree of risk associated with a project 3. generally, the longer the payback period, the higher the risk 4. used to select projects which provide a quick return of invested funds Disadvantages: 1. ignores the time value of money 2...
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