Question

Capital Budgeting HomeworkAssignment Show your calculations. A firm with a cost of capital of 10 percent is considering the following mutually exclusive projects: Year Project A ($450) Project B ($635) 0 60 300 2 60 300 75 75 60 3 70 250 5 250 (a) According to the payback criterion, which project should be accepted? (b) According to the discounted payback criterion, which project should be accepted? (c) According to the NPV criterion, which project should be accepted? (d) According to the IRR criterion, which project should be accepted? According to the MIRR criterion, which project should be accepted? (e) According to the PI criterion, which project should be accepted? (f) Given all the information above, if there is no capital rationing, which project should be chosen and why? (g) Given all the information above, if there is severe capital rationing, which (h) project should be chosen and why?

Answer 1

a]

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period of Project A = 4 + (cash flow required in year 5 for cumulative cash flows to equal zero / year 5 cash flow) = 4 + (10 / 250) = 4.04 years.

Payback period of Project B = 2 + (cash flow required in year 3 for cumulative cash flows to equal zero / year 3 cash flow) = 2 + (35 / 75) = 2.47 years.

Year A B C DE Cumulative Cumulative Cash Cash Cash Flow - Cash Flow - Flow-A Flow - BA (450) (635) (450) (635) 1 60 300 (390) (335) 60 300 (330) 70 (260) 40 4 250 75 115 250 60 240 175 (35) AwN 75 (10) 5

Project B should be accepted as it has a shorter payback period.

b]

Discounted payback period is the time taken for the cumulative discounted cash flows to equal zero

Discounted payback period of Project A = 4 + (cash flow required in year 5 for cumulative discounted cash flows to equal zero / year 5 cash flow) = 4 + (123 / 155) = 4.79 years.

Discounted payback period of Project B = 4 + (cash flow required in year 5 for cumulative discounted cash flows to equal zero / year 5 cash flow) = 4 + (7 / 37) = 4.19 years.

A 1 Year B C F G H I Cumulative Cumulative Discounted Discounted Discounted Discounted Cash Cash Cash Flow - Cash Flow - Cash Flow - Cash Flow - Flow - A Flow - B A (450) (635) (450) (635) (450) (635) 60 273 (395) (362) 60 300 50 248 (346) (114) 53 (293) (58) 171 (123) (7) 250 155 33 300 Nm tin 70 30

А в F H Cumulative Cumulative Discounted Discounted Cash Flow - Cash Flow - -635 1 Year Cash Flow - A Cash Flow - B Cumulative Cash Flow - A 20-450 =B2 3 1 60 300 =D2+B3 4 2 60 300 =D3+B4 5 3 70 =D4+B5 6 4 250 =D5+B6 75 250 =D6+B7 Cumulative Cash Flow - Discounted Cash B Flow -A =C2 =B2/(1+10%)^A2 =E2+C3 =B3/(1+10%)^A3 =E3+04 =B4/(1+10%)^A4 =E4+C5 =B5/(1+10%)^A5 =E5+C6 =B6/(1+10%)^A6 =E6+07 =B7/(1+10%)^A7 Discounted Cash Flow - B =C2/(1+10%)"A2 =C3/(1+10%)^A3 =C4/(1+10%)^A4 =C5/(1+10%)^A5 =C6/(1+10%)^A6 =C7/(1+10%)^A7 =F2 =H2+F3 =H3+F4 =H4+F5 =H5+F6 =H6+F7 =G2 =12+G3 =13+G4 =14+G5 =15+G6 =16+G7

Project B should be accepted as it has a shorter payback period.

c]

NPV is calculated using NPV function in Excel.

Project A should be accepted as it has a higher NPV

f =NPV(10%,B3:37)+B2 K L M J B8 - A B C Cash Cash 1 Year Flow - A Flow-B 0 (450) (635) 60 2 60 300 70 75 250 250 8 NPV 33 1 300

fx =NPV(10%,C3:C7)+C2 K L M A J 1 Year B C Cash Cash Flow - A Flow - B (450) (635) 60 300 60 70 250 75 250 3330 300 75 60 8 NPV

d]

IRR is calculated using IRR function in Excel.

Project B should be accepted as it has a higher IRR.

B9 - fx EIRR(B2:37) BC J K L Cash Cash 1 Year Flow - A Flow - B (450) (635) 60 60 300 70 75 250 75 250 9 IRR 12% 13% 10 300 60

fx EIRR(C2:07) K L. J 09 - A B C Cash Cash 1 Year Flow - A Flow - B 0 (450) (635) 1 60 300 2 60 300 3 70 75 4 250 75 5 250 9 IRR 12% 13% 60