Question

BYD automotive must choose between two directions for the automaker’s future:developing fully electric-powered car or a hybrid-powered car. The company has $30million capital available at a cost of capital of 10%. The $30 million capital needs to bepaid back in 3.5 years.A) The hybrid car project calls for investment of $10 million to build plant and assemblylines right now. For the next four years, the project cash flow from the project will be $5million, $3 million, $3.5 million, and $3.5 million, respectively. After that, the project willbe close down with no salvage value. B)The electric car project calls for $20 million investment to purchase patents andanother $10 million to build plant and assembly lines right now. For the next four years,the project cash flow from the project will be $15 million, $9 million, $9 million, and $11million, respectively. After that, the project will be close down with no salvage value.

Use the above information, fill the table of cash flow (careful about positive or negative sign of the cash flow) for each project.

1) Use the above information, fill the table of cash flow (careful about positive or negative sign of the cash flow) for each project. Project Hybrid Car Project Electric Car Cash Flow Cash Flow Year Year 0 0 1 1 2 2 3 4 4

2).Based on the capital budgeting decision rules, calculate the Payback Period (PB),Discounted Payback Period (DPB), Net Present Value (NPV), and ProfitabilityIndex (PI) for each project.

3)Use Excel function to calculate the Internal Rate of Return (IRR) for both projects.

4)Would each of the projects be taken if it was the onlyproject available? Explain.

5)Can BYD take both of the two projects? If not, which one of the decision criteria listed in part 2) and 3) (PB, DPB, NPV, PI, IRR) will you use for the final decision? Which project should BYD take?

6)Analyze each alternative decision criteria listed in part 2) and 3) by identifying the pros and cons of each. (Textbook might help)

Answer 1

Calculations for part (1), (2) & (3):

3 3.5 Project Hybrid car Formula Year (n) Cash flow (CF) 1/(1+10%)^n Discount factor @ 10% CF*Discount factor PV of CF Sum of all PVS NPV Irr function with CFS (Sum of PV1 to PV4)/PVO Profitability index 0 -101 1.000 -10.00 2.04 19.79% 1.20 1 5 0.909 4.55 2 3 0.826 2.48 3.5 0.751 2.63 0.683 2.39 IRR Formula 0 1 2 3 3.5 Year (n) Cash flow (CF) Cumulative cash flow (CCF) Payback period in years) -10 -10 2.57 -5 -2 CCFn-1 + CFn 2 + (-CCF2/CF3) 1.5 Formula 3 L 2.39 Year (n) PV of CF (PV) Cumulative discounted cash flow (CCF) Discounted payback period in years) 0 - 10.000 -10.00 3.14 4.551 -5.45 2.48 -2.98 2.63 -0.35 2.04 CCFn-1 + PVN 3 + (-CCF3/PV4)

1 3 4 Project Electric car Formula Year (n) Cash flow (CF) 1/(1+10%)^n Discount factor @ 10% CF*Discount factor PV of CF Sum of all PVs NPV Irr function with CFS (Sum of PV1 to PV4)/PVO Profitability index 0 -30 1.000 -30.000 5.351 18.60% 1.18 2 15 9 0.909 0.826 13.647.44 9 0.751 6.76 11 0.683 7.51| IRR Formula 1 2 3 -30 91 Year (n) Cash flow (CF) Cumulative cash flow (CCF) Payback period (in years) 15 -15 -30 31 CCFn-1 + CFn 2 + (-CCF2/CF3) 2.67 Formula Year (n) PV of CF (PV) Cumulative discounted cash flow (CCF) Discounted payback period in years) 0 - 30.00 -30.000 3.29 13.641 -16.36 7.44) -8.93 6. 767 -2.16 .51 5.35 CCFn-1 + PVn 3+ (-CCF3/PV4)

4). Yes, both projects are acceptable on a stand-alone basis as both have positive NPVs and IRRs greater than the cost of capital.

5). BYD cannot take both of the projects as it has a capital constraint of 30 million and both projects together require an investment of 40 million. NPV should be used to decide which project is to be accepted. Based on NPV, Project Electric Car should be accepted.

6). Payback period provides an easy back of the envelope calculation about by when the project will break even but it does not take the time value of money into account. This is addressed in the discounted payback period which is based on discounted cash flows. This provides a better estimate of when the project will break even. However, both these criteria give only the time period and not the return of a project.

NPV is the most useful capital budgeting criteria as it takes into account the time value of money and gives an estimate about how much return (in dollar terms), a project will give.

Profitability index provides an easy metric to gauge whether a project will be profitable or not. A project with a PI of greater than one will be profitable but PI provides only a ratio, not an absolute number so it does not give any other information.

IRR provides the return at which a project will break even (or recover its costs). It is a very useful metric as it gives an idea about the return which a project will generate. However, in case of mutually exclusive projects, with both having IRRs greater than the cost of capital, it would be better to decide on the basis of NPV.