“Capital budgeting involves the calculation of future accounting profit by period, the cash flow by period, the present value of the cash flows after considering the time value of money, the number of years it takes for project’s payback period” (AccountingCoach, LLC, 2014). There are at least six capital budgeting tools you can use in analyzing a capital expenditure: net present value (NPV), internal rate of return (IRR), profitability index (PI), payback period (PB), discounted payback period (DPB), and modified internal rate of return (MIRR), although assignment focuses on net NPV and IRR (University of Phoenix Material, 2014). The calculations that I performed in an excel spreadsheet I performed the extra calculations to ensure that I was making the correct choice for the example.
“The net present value (NPV) is the present value of an investment’s annual free cash flow less the investment’s initial outlay (Keown, Martin, & William-Petty, 2014, p. 310). Company A NPV is $123,939 and Company B NPV is $161,637. Both of the companies has a NPV greater than and or equal to zero. Company B value created is $37,968 more than Company A. This shows the free cash flows rather than accounting profits. Recognizing the time value of money allows the benefits and costs to be compared in a logical manner (Keown, Martin, & William-Petty, 2014).
“The internal rate of return (IRR) is defined as the discount rate that equates the present value of the free cash flows with the initial cash outlay” (Keown, Martin, & William-Petty, 2014, p. 316). The IRR of Company A is 27% and Company B is 33%. Both percentages are acceptable, but Company B’s IRR is higher than Company A. One of the faults associated with the IRR and NPV that uses the assumption that a company will reinvest the company’s cash flow back into the company. The modified internal rate of return (MIRR) the discount rate that equates the present value of the project’s future free cash flows with the terminal value of the cash inflows. This analysis allows the appeal of the IRR coupled with the improved reinvestment rate assumption. There is very little difference in the MIRR of Company A and Company B. Company A MIRR is 15% and Company B MIRR is 18%. Company B still has the higher percent.
The payback period is the number of years need to recover the initial investment. The payback period for Company A is 2.73 years and Company B is 2.39 years. Both companies payback period will take a little more than 2 years, but Company B will have the initial investment returned .34 of year sooner. There