Galaxy Satellite Co. Using the NPV Approach
The NPV method of capital budgeting appraisal is determined by deducting initial cost of investment from the present value of cash inflows realized at the end of the project cycle (Ehrhardt and Eugene 327). The decision rule of NPV is to accept the project with higher NPV and reject alternatives projects with lower NPV, as project with higher NPV has a higher potential of wealth maximization. Table 1 indicates the calculations of the NPV generated by independent projects being appraised by Galaxy Satellite Co.
NPV
Calculation
Project
PV of Inflows
Initial Investment
NPV
A
3,050,000.00
3,000,000.00
50,000.00
B
9,320,000.00
9,000,000.00
320,000.00
C
1,060,000.00
1,000,000.00
60,000.00
D
7,350,000.00
7,000,000.00
350,000.00
Table 1: NPV Calculations
Using the NPV decision rule, project group to be chosen is a combination of Project C and Project D as they have higher NPV values and it is likely to produce more wealth maximization than other projects, bearing in mind that the fixed budget of the company for investment is only $10,000,000.00 The combined NPV amounts of the selected group of projects is $60,000 plus $350,000 = $410,000. Therefore, the company will have to incur the initial cash outlay of just $8,000,000 for higher wealth maximization, which is highly dependent on the budgeted amount of investment.
Using the IRR Approach
The IRR is defined as the rate of return on investment generated when the NPV is zero (Glynn 250). In other words, IRR is thought as a growth rate which the project is anticipated to generate at the end of the project life. The IRR measures the value the project is likely to add to the company. The decision rule of IRR approach rejects the project whose IRR is less than cost of capital and accepts those projects whose IRR is beyond the cost of capital. For projects whose IRR s are higher than cost of capital, the project with a higher IRR is chosen. Table 2 shows the project’s IRR and Initial Investment.
Project
Initial Investment
IRR
A
$3,000,000
21%
B
$9,000,000
25%
C
$1,000,000
24%
D
$7,000,000
23%
Table 2: IRR and Initial Investment
Based on the company’s budget and IRR approach, Project B and Project C are chosen. This group of projects consists of projects with higher IRRs and they are within the company’s budget of $10,000,000.00. Within the company’s budget Project B and Project C are likely to bring higher growth rate to the Galaxy Satellite Co. However, the NPV of the combined projects based on IRR approach is just $380,000.
An Email on the Best Project based on NPV and IRR approach
From: …[email protected]
Subject: Project Appraisal
Dear Andy Fast, I am writing this email to explain my rational to prove my choices regarding the best group of projects the company should undertake taking into the account the maximization of shareholders’ wealth and the budget limit set by the company. However, I am not more concerned about using the whole budget, but I am more conscious on maximization of the total return to the company. There are two group of projects that were under consideration, C & D (NPV approach) and B & C (IRR approach). In this case I chose C $ D project group because they have higher NPV ($410,000) and lower budget of just $8,000,000. B & C project is rejected because of lower NPV ($380,000) and higher budget of $10,000,000. In conclusion, NPV approach has an upper hand when compared to IRR approach.
Works Cited
Ehrhardt, Michael C, and Eugene F. Brigham. Corporate Finance: A Focused Approach. Mason, OH: South-Western/Cengage Learning, 2009. Print.
Glynn, John J. Accounting for Managers. London: Cengage Learning, 2008. Print.
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