A company is thinking of investing some surplus cash in 30 years $1000 face microsoft 6% coupon bonds. It plans to pay $925 each for 10,000 of them, now and expects to sell them for $1025 each at the end of 5 years. Make a determination about the economic viability of the proposal using 3 capital budgeting methods.
To determine the economic viability of the proposal, let's evaluate it using three common capital budgeting methods: Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period.
1. Net Present Value (NPV):
The NPV method calculates the present value of cash inflows and outflows, taking into account the time value of money. The formula for NPV is:
NPV = Σ[(Cash inflow / (1 + r)^n) - Cash outflow]
Where:
- Cash inflow: Future cash flow expected from the investment (selling the bonds after 5 years).
- Cash outflow: Initial investment (buying the bonds now).
- r: Discount rate or required rate of return.
- n: Time period.
In this case, the cash inflow is the expected selling price after 5 years ($1025), cash outflow is the initial investment price ($925), r is the desired rate of return (usually the company's cost of capital), and n is the time period (5 years).
Calculate the NPV by plugging in the values into the formula:
NPV = [(1025 / (1 + r)^5) - 925] * 10,000
If the calculated NPV is positive, the proposal is economically viable. If it is negative, the proposal may not be economically viable.
2. Internal Rate of Return (IRR):
The IRR method calculates the discount rate that equates the present value of cash inflows and outflows. It helps identify the rate of return the investment would generate.
In this case, we need to find the discount rate that makes the NPV of the proposal equal to zero. An IRR greater than the company's cost of capital indicates economic viability.
Use trial and error or financial software to find the IRR that results in NPV = 0.
3. Payback Period:
The payback period is the time taken to recover the initial investment. If the payback period is shorter than the desired time frame, the investment is considered viable.
Calculate the payback period by dividing the initial investment by the annual cash flow:
Payback period = Initial investment / Annual cash flow
The annual cash flow is the expected cash inflow per year, which is the selling price minus the purchase price divided by the time period (5 years).
If the payback period is shorter than the company's desired time frame, the investment is economically viable.
Evaluate the proposal using these three methods to determine its economic viability.