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Topic 3 Probelms and Applications

The document outlines various problems related to capital budgeting decisions, focusing on net present value (NPV) calculations for different investment scenarios. It includes examples such as equipment purchases, project cash inflows, and comparisons of alternative investments, requiring the application of NPV and internal rate of return (IRR) techniques. The document serves as a practical guide for evaluating investment feasibility and making informed financial decisions.

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9 views2 pages

Topic 3 Probelms and Applications

The document outlines various problems related to capital budgeting decisions, focusing on net present value (NPV) calculations for different investment scenarios. It includes examples such as equipment purchases, project cash inflows, and comparisons of alternative investments, requiring the application of NPV and internal rate of return (IRR) techniques. The document serves as a practical guide for evaluating investment feasibility and making informed financial decisions.

Uploaded by

bdrsabiir
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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University of Algiers 3

Faculty of Economics, Commercial Sciences and Management Sciences


Financial Sciences and Accounting Department Corporate Financial Policies

Topic 3: Investment policy: Capital Budgeting Decisions / PROBLEMS AND APPLICATIONS

Problem 1:
The management of Fine Electronics Company is considering to purchase an equipment to be attached
with the main manufacturing machine. The equipment will cost $6,000 and will increase annual cash
inflow by $2,200. The useful life of the equipment is 6 years. After 6 years it will have no salvage
value. The management wants a 20% return on all investments.
Required:
a. Compute net present value (NPV) of this investment project.
b. Should the equipment be purchased according to NPV analysis?
Problem 2:
A project requires an initial investment of $225,000 and is expected to generate the following net cash
inflows over its four years life:
Year 1 2 3 4
CFt ($) $95,000 $80,000 $60,000 $55,000

Required: Compute net present value of the project if the minimum desired rate of return is 12%.
Problem 3:
Maruti is in the business of auto, and they want to start their subsidiary business as an expansion plan
for assembling the auto part, so they had provided the below information for calculating the NPV.
They want to know should this project will be feasible or not.
The project requires an initial investment of $20,000 financed by 4,000 as equity, and 16,000 as debt,
and is expected to generate the following net cash inflows over its four years life:
Year 1 2 3 4 5 6 7
CFt ($) $-12,000 $10,000 $11,000 $12,000 $13,000 $14,000 $15,000
• Cost of Equity: 35%
• Cost of Debt: 15%
• Corporate Tax Rate: 30%
Required: Find the NPV with the help of WACC.

Problem 4:
You have been asked to compare three alternative investments and make a recommendation.
• Project A has an initial investment of $5 million and after-tax cash flows of $2.5 million a year for
the next five years.
• Project B has no initial investment, after-tax cash flows of $1 million a year for the next 10 years,
and a salvage value of $2 million (from working capital).
• Project C has an initial investment of $10 million, another investment of $5 million in 10 years, and
after-tax cash flows of $2.5 million a year forever.
The discount rate is 10% for all three projects.
Required: By using the NPV technique, which of the three projects would you pick? Why?

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Corporate Financial Policies CFP https://prof-mebani.com
University of Algiers 3
Faculty of Economics, Commercial Sciences and Management Sciences
Financial Sciences and Accounting Department Corporate Financial Policies

Problem 5:
You are a small business owner considering two alternatives for your phone system.

Plan A Plan B
Initial cost ($) 50,000 120,000
Annual maintenance cost ($) 9,000 6,000
Salvage value ($) 10,000 20,000
Life 2 years 4 years

The discount rate is 8%.


Required:
a. By using the NPV technique, which alternative would you pick? Why?
b. By using the IRR technique, which alternative would you pick? Why?
Problem 6:
You work for a firm that has a ready supply of good projects, and you have listed all of them.

Project A Project B Project C


Present Value of cash flows ($) 212,000 171,800 185,200
Initial cost ($) 200,000 160,000 180,000
Net Present Value ($) …….…? ……….? ………?

a. Based on the NPV, which of these projects would you choose?


b. Based on the profitability index PI, which of these projects would you choose?
Problem 7:

You work for a firm that has limited access to capital markets. As a consequence, it has only $20
million available for new investments this year. The firm does have a ready supply of good projects,
and you have listed all the projects.

Projects Initial investment: I0 ($ million) NPV ($ million) IRR (%)


A 10 3 21%
B 5 2.5 28%
C 15 4 19%
D 10 4 24%
E 5 2 20%

Required:
a. Based on the profitability index IP, which of these projects would you take?
b. Based on the IRR, which of these projects would you take?
c. Why might the two approaches give you different answers?

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Corporate Financial Policies CFP https://prof-mebani.com

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