Capital Budgeting Case the Contemporaneous Research Proposal

Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first."

The equation to calculating the internal rate of return is a complex one, based primarily on the value of the initial investment:

(Yousaf)

In the case of the first investment project, the equation to calculating the IRR would be as follows:

130 = 25 / (1 + r) 1 + 35 / (1 + r) 2 + 45 / (1 + r) 3 + 50 / (1 + r) 4 + 55 / (1 + r) 5

For project B, the equation is:

85 = 40 / (1 + r) 1 + 35 / (1 + r) 2 + 30 / (1 + r) 3 + 10 / (1 + r) 4 + 5 / (1 + r) 5

Given the complexity of these formulas, the method used is that of estimating results and verifying until a correct solution is identified. "We use linear interpolation to estimate the actual rates of return for the four investment alternatives. Linear interpolation is a trial and error method of estimating actual rates of return when such rates are different from tables or calculators" (Yousaf).

For project A, an estimated internal rate of return of 9% would lead to the following:

130 = 25 / 1.09 + 35 / 1.18 + 45 / 1.29 + 50 / 1.41 + 55 / 1.53 130 = 158.89, which is false, meaning then that the IRR for project A is larger than 9%. Considering an IRR of 11%:

130 = 25 / 1.11 + 35 / 1.23 + 45 / 1.36 + 50 / 1.51 + 55 / 1.68 130 = 149.91, which is also false, requiring the need for an even larger estimation. For an IRR of 15%:

130 = 25 / 1.15 + 35 / 1.32 + 45 / 1.52 + 50 / 1.75 + 55 / 2.01 130 = 133.79; this result is the closest one, meaning then that the estimated IRR for project investment A is of 15.5%

For project B, the estimative calculations commence at a value of the internal return rate of 10%:

85 = 40 / 1.1 + 35 / 1.21 + 30 / 1.33 + 10 / 1.46 + 5 / 1.6 85 = 97.82, which is clearly false, meaning as such that the IRR is larger. For an estimated IRR of 15%:

85 = 40 / 1.15 + 35 / 1.32 + 30 / 1.52 + 10 / 1.75 + 5 / 2.01 85 = 89.23

Based on the previous calculations, the probable internal rate of return for project B. is of 16%, 0.05% greater than the IRR of investment project A. In this light of events, the most desirable investment seems project B.

As initially foreseen, the calculations of the net present value and the internal rate of return have generated different solutions, meaning then that the final decision is based on the correlation to the capital rationing constraint. This argues that the first investment project is the most desirable one as the goal is that of long-term profitability and limited focus is being placed on costs incurred, as long as the set profitability goals are established.

4. The Selected Investment Project

The analysis of the two proposed investment projects in light of financial tools and organizational preferences has established the fact that the first project is the one to be implemented and generate the highest levels of profitability. Considering that project A is implemented, it would lead to modifications in the capital structure as follows:

long-term debt would decrease from 25% to only 20% preferred stock would also decreased from 25 to 20%, and finally common stock and retained earnings would increase from 50 to 60%

Modifications would also occur in the…