Practice Problem Set #8: Capital budgeting

Theoretical and conceptual questions: (see notes or textbook)

1. What is meant by a ‘capital budgeting’ decisions? Provide examples of capital budgeting decisions
that CFOs of corporations would make.
2. What are the characteristics we look for in a good investment criteria?
3. How does NPV compare to Payback, IRR and Profitability Index when we apply the criteria in 2.?
4. Your manager is a CPA and insists on using Accounting Return as the main investment criteria.
How do you respond?
5. The owner-manager of the company you work for insists on using the Payback rule as the main
investment criteria for a risky project with a 20 year project life. How do you respond?
6. Differentiate between conventional and unconventional project cash flows.
7. Under what circumstances could NPV and IRR lead to conflicting answers?
8. Why is IRR a popular investment criteria among financial managers?
9. Provide an example of a sunk cost of a project. Would you include it in the project cash flows?
10. Provide an example of an opportunity cost of a project. Would you include it in the project cash
flows?
11. What is meant by the standalone principle?
12. Why is it important to do sensitivity, scenario or breakeven analyses for projects?
13. The City of Vancouver is contemplating the automation of the cleaning of facilities by using robots to
clean floors of community centres. A pilot of this project was done at UBC and at the Vancouver
airport and the technology works well. The NPV of the project is also positive. Consider the
qualitative effect of their decision on stakeholders.

Practice Problems:

You have been asked to analyze the following two mutually exclusive projects for a client. The client’s
cost of capital is 15% (this is also the required rate of return). You have already done all the calculations
for Project A. Using a spreadsheet you have determined the internal rate of return (IRR) for the projects.
You have also determined that the cross-over rate (incremental IRR) is 23.22%.

Year Cash Flow (Project A) Cash Flow (Project B)

0 -240,000 -18,000

1 10,000 10,000

2 25,000 6,000

3 100,000 10,000

4 380,000 8,000

NPV $70,617 ?

IRR 23.63% 32.01%

Payback Period 3.28 years ?

Profitability Index ? ?
 Required:

1. Calculate the Payback Period for Project B. Which project do you recommend based on the
Payback Period as investment criteria?
2. What is the main benefit and disadvantage of using Payback Period?
3. Project B has a higher IRR than Project A. Why would you be careful to use IRR as the main
decision criteria to decide between Project A and Project B?
4. Calculate the Net Present Value (NPV) for Project B. Which project do you recommend based
on NPV?
5. Calculate the Profitability Index (PI) for both Projects.
6. Is PI useful in making an investment decision regarding Project A and Project B?
7. What is the significance of the cross-over rate or the incremental IRR?

Mini cases:

Question #1

A university athletic department is considering replacing the natural grass turf in its stadium with artificial
turf. By putting artificial turf in the stadium, the university would have better playing conditions for its
athletes. Additionally, high school playoff games could be played in the stadium, which would generate
additional revenues for the university’s athletic programs.

There are problems with the natural grass field that was installed last year in the stadium. Because of
these problems, the university will receive a rebate of $250,000 if it chooses to replace the grass field
with an artificial surface. Installing artificial turf would cost $719,500. The initial cost of the investment
would be only $469,500, however, as the $250,000 rebate would be applied to the invoice cost of the
field. With this field, the university could host three high school playoff dates per year. The games would
generate $180,000 in incremental cash flow from rental fees, and $35,000 in incremental cash flow from
parking and concession revenues, after expenses.

The university would have to make payments on the field at an annual rate of 7%. The life of the field is
estimated to be ten years.

a) Use NPV to determine whether the university should install artificial turf or keep the stadium’s
current natural grass field.

Question #2

Repellent Pharmaceuticals has invested $300,000 to date in developing a new type of insect repellent.
The repellent is now ready for production and sale, and the marketing manager estimates that the product
will sell 150,000 bottles a year over the next five years. The selling price of the insect repellent will be $5
a bottle and variable costs are estimated to be $3 a bottle. Fixed costs are expected to be $200,000 a
year. This figure is made up of $160,000 new fixed costs and $40,000 fixed costs relating to the existing
business that will be apportioned to the new product.
In order to produce the repellent, machinery and equipment costing $520,000 will have to be purchased
immediately. The estimated salvage value of this machinery and equipment in five years’ time is
$100,000. Repellent Pharmaceuticals has a cost of capital of 12%.

a) Calculate the NPV of the product.

Question #3

Blasting Tools Ltd. manufactures mining equipment. A few years ago, Blasting Tools spent $450,000 on
some vacant land on which to build a second factory. Since this is a slow period and Blasting Tools does
not want to lay off experienced employees, the current factory has idle capacity for its workforce.

Blasting Tools is considering an expansion plan for building a new factory on the vacant land. However,
if the decision is made not to expand, the vacant land could be sold for $470,000 now. Materials would
cost $2,000,000. One hundred of Blasting Tool’s current employees, each paid at the rate of $4,000 per
month, would construct the factory building. It would take one month to complete the construction.

Cash flows from additional sales would amount to $500,000 per year for the next five years. Assume
each of these amounts is received at year-end. After five years, it is expected there will be no need for
the second factory due to reduced demand for mining equipment. The land and building are expected to
be sold for $600,000 ($500,000 for the land and $100,000 for the building) at that time.

a) Identify the relevant cash flows if Blasting proceeds with the construction of the new factory.
b) Calculate the NPV of these cash flows, assuming a discount rate of 8%.
c) Now assume that the fair value of the land at the beginning of the project remains at $450,000
and the land cannot be sold, according to city bylaw, until the end of the fifth year, when it would
sell for $500,000. How would this affect the NPV?

Question #4

Mega operates nail salons and has an opportunity to lease new space adjacent to an existing store for
10 years. To secure the space they paid a $5,000 non-refundable deposit for the space last year. Costs
for remodeling and for new equipment would be $550,000 (including $50,000 installation costs). The
equipment would have a salvage value of $30,000 in 10 years, when the lease ends. An additional $7,500
of working capital would be needed in the beginning of the project to handle the larger volume of business.
This working capital would be recovered at the end of the lease term. Management is confident that
incremental cash flow from the salon would add $107,000 per year to the $150,000 of the existing store.
The weighted average cost of capital for the company is 10%. Management believe that this project is of
a ‘very low risk’ category. Management adjusts the cost of capital for projects as follows:
 - Very high risk: +8%
- High risk: +4%
- Medium risk: +0%
- Low risk: -2%
- Very low risk: -4%

a) Calculate the Net Present Value (NPV) of the expansion and make a recommendation to
management.
b) Do a sensitivity analysis: Find the breakeven level of annual cash flow where NPV is zero.
c) You realized that your original equipment cost estimate is $50,000 too low and upon further
research the project is more risky than first anticipated. How would this new cost estimate and your
re-classification of the project as a ‘High Risk’ project change your NPV and your original
recommendation in a)?