Step 2 – basic capital budget analysis

  

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As the manager of the pension fund, you are frequently targeted by software companies peddling investment simulation software.  You have finally narrowed down your choice to two applications.  You need to analyze the options by calculating NPV, IRR and Payback Period based on their purchase price and savings to your company over time.  Your staff has prepared a cash-flow table to help you.  Year zero shows the purchase price of each application, and the figures listed for years 1-3 represent the savings to the company in successive years.

   

Year

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Application I

Application II

 

0 (today)

-$1.5 million

-$1 million

 

1

$0.8 million

$0.5 million

 

2

$0.7 million

$0.24 million

 

3

$0.3 million

$0.6 million

You are considering three possible scenarios. 

Question 7: If the payback period is two years, which application should be selected?

Question 8: If the required rate of return is 15 percent, which application should be selected?

Question 9: If the selection criterion is IRR, which application should be selected?

Respond to the questions 7, 8, and 9 above by submitting a single, integrated report that shows your supporting data and calculations. Finally, provide a recommendation and rationale for purchasing either Application I or Application II. 

Be sure to show your calculations in Excel and provide a narrative analysis in Excel.  Your narrative analysis should include your recommendation and rationale for purchasing either Application I or Application II.

Before you submit your assignment, review the competencies below, which your instructor will use to evaluate your work. A good practice would be to use each competency as a self-check to confirm you have incorporated all of them in your work.

  • 3.1 Identify numerical or mathematical      information that is relevant in a problem or situation.
  • 3.2 Employ mathematical or statistical      operations and data analysis techniques to arrive at a correct or optimal      solution.
  • 3.3 Analyze mathematical or statistical      information, or the results of quantitative inquiry and manipulation of      data.
  • 3.4 Employ software applications and analytic      tools to analyze, visualize, and present data to inform decision-making.
  • 10.3 Determine optimal financial decisions in      pursuit of an organization’s goals.
  • 10.4 Make strategic managerial decisions for      obtaining capital required for achieving organizational goals.

Additional Guidance on Project 4

Ques 7.  Payback period — how long will it take to recoup the initial investment.  If $X invested today, given expected cash inflow over time — the question becomes, how long will it take to recoup the initial investment $X.  Be sure calculate the precise period of time, which often times is a mixed number like 2 1/2 years.

Ques 8.  Run the NPV in Excel for each option and determine which option is better.  Use = NPV(………) and Excel will display the requirements.  Note that Year 0 is already in present value format so do not include Year 0 in your PV cash flow range.  However, you will need to deduct the initial investment from the PV of future cash flows, like = NPV(CF1….CFN) – Initial Investment.

Ques 9.  For IRR calculation, use =IRR(CF0…CFN), include the entire cash flow stream.

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