In the attached Excel Worksheet, we have analyzed the viability of acquiring company A or Company B. For the purpose of analysis, we have used two of the popular capital budgeting techniques, i.e. Net Present Value(NPV) and Internal Rate of Return(IRR).
NPV: It refers to the sum of the present value of all the expected incremental cash flows if a project is undertaken. The discount rate used, represents the firm’s cost of capital, adjusted for the risk level of the project. For a normal project just as provided In the given case study where the initial cash outflow is followed by a series of expected after tax cash inflows, The NPV is the present value of the expected cash inflows minus the initial cost of the project.
IRR: It refers to the discount rate that makes the present value of the expected incremental after tax cash inflows just equal to the initial cost of the project. In other words, it is the discount rate that makes the present value of a project’s estimated cash inflows equal to the present value of the project’s estimated cash outflows. Thus, the discount rate calculated through IRR, makes the following relationship hold:
Present Value of Cash Inflows= Present Value of Cash Outflows
Relationship between NPV and IRR:
Both IRR and NPV carriers a complex relationship with each other. While both NPV and IRR are used to evaluate a potential capital project or investment, IRR is used to measure the potential growth percentage of the investment. However, NPV , on the other hand indicates the present value of the project today using the discounting the cash flows of the project.
Thus, IRR acts a break-even for the project i.e. the rate at which NPV of the project will be zero(0).
The case offers us to analyze the acquisition of two different corporation with different cash flows projection. However, since the purchasing company only have $250000, it can only select to invest in one of the corporation.
In order to come up with a concrete and validated solution, we used two popular capital budgeting techniques, NP analysis and IRR for valuation of both the corporation.
As for Company A, with the projected 5 year cash flows, we found that if the Company A is acquired, this will provide the buyer with positive NPV of $27466 and IRR of 13.94%. Furthermore, since, the IRR is greater than the cost of capital of 10% and project has positive NPV, the buyer can surely accept acquiring Company A.
In another situation also, where the buyer can consider acquisition of Company B, if he invest in this corporation, he will be having NPV of $40248 and IRR of 16.94%. Here also, the project is offering IRR greater than the cost of capital rate of 11% and positive NPV.
Here we are faced with the problem of Multiple NPV and IRR. However, based on the financial rules, the buyer should only accept the project with maximum amount of NPV i.e. Company B. This is because, if this project is added, this will increase the shareholder value by maximum amount.