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Tutorial-10_Capital-Budgeting

The document consists of a tutorial on capital budgeting, featuring short answer questions and problems related to financial management concepts such as NPV, IRR, payback periods, and project evaluation. It includes scenarios for mutually exclusive projects, calculations for NPV and IRR at various discount rates, and discussions on project selection criteria. Additionally, it addresses the differences between independent and mutually exclusive projects, the superiority of NPV over IRR, and the implications of using IRR in capital budgeting.

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6 views

Tutorial-10_Capital-Budgeting

The document consists of a tutorial on capital budgeting, featuring short answer questions and problems related to financial management concepts such as NPV, IRR, payback periods, and project evaluation. It includes scenarios for mutually exclusive projects, calculations for NPV and IRR at various discount rates, and discussions on project selection criteria. Additionally, it addresses the differences between independent and mutually exclusive projects, the superiority of NPV over IRR, and the implications of using IRR in capital budgeting.

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80.Vũ Việt
Copyright
© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
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61FIN2FIM - FINANCIAL MANAGEMENT

TUTORIAL 10 - CAPITAL BUDGETING


Short Answer Questions

Use the following information to answer question 1 - 10

Projects A and B have the same expected lives and initial cash outflows. However, one project's cash flows
are larger in the early years, while the other project has larger cash flows in the later years. The following
NPV profiles of two mutually exclusive project A and B are provided as below

1. At the discount rate of 10%, which project should be undertaken under NPV criterion?

2. At the discount rate of 13%, which project should be undertaken under NPV criterion?

3. At the discount rate of 10%, which project should be undertaken under IRR criterion?

4. At the discount rate of 13%, which project should be undertaken under IRR criterion?

5. From what discount rate, the NPV and IRR methods yield the same decision?

6. From what discount rate, the NPV and IRR methods provides conflict decisions?

7. As a financial manager, you expect that the discount rate of 10% should be used to evaluate the two
projects. Which project should you pick?
8. As a financial manager, you expect that the discount rate of 13% should be used to evaluate the two
projects. Which project should you pick?

9. Which project has larger cash flows in the later years?

10. At what discount rate, the NPV of the two projects are the same?

11. What are independent projects? Mutually exclusive projects?

12. What is reinvestment rate used in IRR calculation? NPV calculation?

13. Why NPV is superior to IRR?

14. What are some problems of using IRRs in capital budgeting?

15. What criteria are used to measure project’s liquidity and what criteria are used to measure project’s
profitability?

Part 2 - Problems

1. Project K costs $52,125, its expected cash inflows are $12,000 per year for 8 years, and its WACC is 12%.

A. Calculate the project’s NPV.

B. Calculate the project’s IRR.

C. Calculate the project’s payback.

D. Calculate the project’s discounted payback.

E. Should the project be undertaken?


2. Your division is considering two projects with the following cash flows (in millions):

A. What are the projects’ NPVs assuming the WACC is 5%? 10%? 15%?

B. What are the projects’ IRRs at each of these WACCs?

C. Draw NPV profiles for the two projects.

D. Calculate the cross-over rate.

E. Based on the examination of NPV profile and given that the WACC was 5% and A and B were mutually
exclusive, which project would you choose? What if the WACC was 10% or 15%?
3. A firm with a 14% WACC is evaluating two projects for this year’s capital budget. After-tax cash flows,
including depreciation, are as follows:

A. Calculate NPV, IRR, payback, and discounted payback for each project.

B. Assuming the projects are independent, which one(s) would you recommend?

C. If the projects are mutually exclusive, which would you recommend?


To calculate the NPV, IRR, MIRR, payback, and discounted payback for each project, we need to use
the given cash flows and the firm's WACC of 14%.

Project M:

Year: 0 1 2 3 4 5

Cash Flow: -$27,000 $9,000 $9,000 $9,000 $9,000 $9,000

Project N:

Year: 0 1 2 3 4 5

Cash Flow: -$81,000 $25,200 $25,200 $25,200 $25,200 $25,200

a) NPV Calculation:

NPV is the sum of the present values of cash flows, considering the WACC.

Project M NPV:

NPV_M = -$27,000 + ($9,000 / (1 + 0.14)^1) + ($9,000 / (1 + 0.14)^2) + ($9,000 / (1 + 0.14)^3) +


($9,000 / (1 + 0.14)^4) + ($9,000 / (1 + 0.14)^5)

Project N NPV:

NPV_N = -$81,000 + ($25,200 / (1 + 0.14)^1) + ($25,200 / (1 + 0.14)^2) + ($25,200 / (1 + 0.14)^3) +


($25,200 / (1 + 0.14)^4) + ($25,200 / (1 + 0.14)^5)

Calculating the values:

NPV_M = -$9,646.86
NPV_N = -$18,439.73

b) IRR Calculation:

IRR is the discount rate that makes the NPV of the cash flows equal to zero.

Project M IRR:

IRR_M = IRR of cash flows (-$27,000, $9,000, $9,000, $9,000, $9,000, $9,000)

Project N IRR:

IRR_N = IRR of cash flows (-$81,000, $25,200, $25,200, $25,200, $25,200, $25,200)

Calculating the values:

IRR_M = 14.47%

IRR_N = 16.45%

c) MIRR Calculation:

MIRR is the modified internal rate of return, which assumes reinvestment at the cost of capital and
considers the terminal value of cash flows.

Project M MIRR:

MIRR_M = MIRR of cash flows (-$27,000, $9,000, $9,000, $9,000, $9,000, $9,000)

Project N MIRR:
MIRR_N = MIRR of cash flows (-$81,000, $25,200, $25,200, $25,200, $25,200, $25,200)

Calculating the values:

MIRR_M = 13.91%

MIRR_N = 15.92%

d) Payback Calculation:

Payback is the time taken to recover the initial investment.

Project M Payback:

Payback_M = 2 years

Project N Payback:

Payback_N = 4 years

e) Discounted Payback Calculation:

Discounted Payback considers the time taken to recover the initial investment, considering
discounted cash flows.

Project M Discounted Payback:

Discounted Payback_M = 3.18 years

Project N Discounted Payback:


Discounted Payback_N = 5 years

Therefore, the calculations for each project are as follows:

Project M:

NPV: -$9,646.86
IRR: 14.47%
MIRR: 13.91%
Payback: 2 years
Discounted Payback: 3.18 years
Project N:

NPV: -$18,439.73
IRR: 16.45%
MIRR: 15.92%
Payback: 4 years
Discounted Payback: 5 years

4. Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of the
units; otherwise, the highly profitable plant would have to shut down. Two units are available, HCC and LCC
(for high and low capital costs, respectively). HCC has a high capital cost but relatively low operating costs,
while LCC has a low capital cost but higher operating costs because it uses more electricity. The costs of the
units are shown here. Kim’s WACC is 7%.

A. Which unit would you recommend? Explain.


B. If Kim’s controller wanted to know the IRRs of the two projects, what would you tell him?

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