MBA Tutorial: Finance Case Study110

Case Study: The Capital Budgeting Decision

A company is considering investing in a new project that requires an initial investment of $1 million. The project is expected to generate annual cash flows of $200,000 for the next five years. The company's cost of capital is 10%. Should the company invest in the project?

Solution:

To evaluate the project, we will use the net present value (NPV) method. The NPV is the sum of the present value of all future cash flows minus the initial investment. The present value of a cash flow is the amount of money that would need to be invested today to grow to the value of the cash flow at a given point in the future, at the specified rate of return.

The NPV of the project is calculated as follows:

NPV = -Initial investment + Present value of future cash flows

NPV = -$1 million + ($200,000 / 1.10) + ($200,000 / 1.10^2) + ($200,000 / 1.10^3) + ($200,000 / 1.10^4) + ($200,000 / 1.10^5)

NPV = -$1 million + $181,818.18 + $165,289.25 + $150,263.32 + $136,594.83 + $123,913.48

NPV = $96,882.06

Because the NPV of the project is positive, the company should invest in the project.

Conclusion

The net present value method is a useful tool for evaluating capital budgeting decisions. By considering the time value of money, the NPV method can help companies make informed decisions about which projects to invest in.

Additional Resources

2025-02-01

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