Question

1. The most popular capital budgeting techniques used in practice to evaluate and select projects are payback period, Net Present Value (NPV), and Internal Rate of Return (IRR).

2. Payback period is the number of years required for a company to recover the initial investment cost.

3. Net Present Value (NPV) technique: NPV is found by subtracting a project’s initial cost of investment from the present value of its cash flows discounted using the firm’s weighted average cost of capital. It shows the absolute amount of money in dollars that the project is expected to generate.

                    Decision Criteria of NPV

If NPV > 0, accept the project

If NPV < 0, reject the project

The decision rule for mutually exclusive project is to select the project with the highest NPV.

4. Internal Rate of Return (IRR) is the intrinsic rate of return the project is likely to generate. The IRR is the discount rate or the rate of return that will equate the present value of the cash outflows with the present value of the cash inflows (i.e. NPV = 0).

                             Decision Rule:

Accept the project if IRR > cost of capital

Reject the project if IRR < cost of capital

Exhibit 1: The expected cash flows in US$ from the project in Ohio and North Dakota.

Year	Cash flow (Ohio)	Cash flow (ND)
0	(2,000,000)	(2,200,000)
1	180,000.00	150,000.00
2	240,000.00	180,000.00
3	280,000.00	200,000.00
4	300,000.00	290,000.00
5	520,000.00	380,000.00
6	480,000.00	590,000.00
7	530,000.00	410,000.00
8	585,000.00	583,000.00
9	590,000.00	580,000.00
10	592,000.00	620,000.00

The company’s policy is to select projects using NPV technique.

1. You have been hired as a financial consultant to help evaluate the project. Baldwin Inc. wants you to do the following:

a. Calculate the payback period for the two projects.

b. Calculate the IRR of both projects.

c. Use the NPV technique to recommend which investment project it should accept, assuming the cost of capital of financing the Ohio project is 12% and 10% for the North Dakota project?

2. Gregg knows how bad forecast can ruin capital budgeting decisions. If the cost of capital changes from 12% to 13% for Ohio project and remains the same for ND project, does the company have to pursue the project?

Answer 1

Q1)

A) Pay- back period Calculation:

Project Ohio

Year	Cashflow	Cumulative Cash flow
0	($2,000,000)	($2,000,000)
1	180,000	($1,820,000)
2	240,000	($1,580,000)
3	280,000	($1,300,000)
4	300,000	($1,000,000)
5	520,000	($480,000)
6	480,000	0
7	530,000	$530,000
8	585,000	$1,115,000
9	590,000	$1,705,000
10	592,000	$2,297,000

Pay back period of Ohio - 6years.

Project North Dakota

Year	Cashflow	Cumulative Cash flow
0	($2,200,000)	($2,200,000)
1	$150,000	($2,050,000)
2	$180,000	($1,870,000)
3	$200,000	($1,670,000)
4	$290,000	($1,380,000)
5	$380,000	($1,000,000)
6	$590,000	($410,000)
7	$410,000	0
8	$583,000	$583,000
9	$580,000	$1,163,000
10	$620,000	$1,783,000

Pay back period of North Dakota Project is 7years.

B) IRR Calculation

Project Ohio

Year	Cash flow	discount factor 12%	PV discount factor@12%	discount factor 15%	PV Cashflow @15%
0	($2,000,000)
1	$180,000	0.893	$160,740	0.870	$156,600
2	$240,000	0.797	$191,280	0.756	$181,440
3	$280,000	0.712	$199,360	0.658	$184,240
4	$300,000	0.636	$190,800	0.572	$171,600
5	$520,000	0.567	$294,840	0.497	$258,440
6	$480,000	0.507	$243,360	0.432	$207,260
7	$530,000	0.452	$239,560	0.376	$199,280
8	$585,000	0.404	$236,340	0.327	$191,295
9	$590,000	0.361	$212,990	0.284	$167,560
10	$592,000	0.322	$190,624	0.247	$146,224
		Cumulative Cash Inflow	$2,159,894		$1,874,039
		Less: Cash outflow	(2,000,000)		$(2,000,000)
		NPV	$159,894		($135,961)

IRR = 12%+ $159,894/($159,894+$135,961) × (15-12)%

IRR= 12%+ $159,894/$295,855 × (3)%

IRR = 12%+ 1.621% = 13.621%

IRR Calculation for North Dakota Project

Year	Cashflow	Discount factor 10%	PV Cashflow@10%	Discount factor 8%	PV Cash flow@8%
1	$150,000	0.909	$136,350	0.926	$138,900
2	$180,000	0.826	$148,680	0.857	$154,260
3	$200,000	0.751	$150,200	0.794	$158,800
4	$290,000	0.683	$198,070	0.735	$213,150
5	$380,000	0.621	$235,980	0.681	$258,780
6	$590,000	0.564	$332,760	0.630	$371,700
7	$410,000	0.513	$210,330	0.583	$239,030
8	$583,000	0.467	$272,261	0.540	$314,820
9	$580,000	0.424	$245,920	0.500	$290,000
10	$620,000	0.386	$239,320	0.463	$287,060
	Cumulative Cashflow		$2,169,651		$2,426,500
	Less: Investment		$2,200,000		$2,200,000
	NPV		$(30,349)		$226,500

IRR = 8%+ $226,500/(226,500+30,349) × ( 10-8)%

IRR = 8% + $226,500/$256,849 × 2%

IRR = 8%+ 1.763% = 9.7636%

C) NPV

Check table of (B) question.

OHIO PROJECT @ 12%

CUMULATIVE CASHFLOW @12% is $2,159,894

Investment =$2,000,0000

NPV = $2,159,894 - $2,000,000 = $159,894

NORTH DAKOTA @ 10%

Cumulative Cashflow = $2,169,651

Investment =$2,200,000

NPV = $ 2,169,651 - $2,200,000 =$( 30,349)

PROJECT OHIO is accepted as it has positive NPV.

2)

NPV CALCULATION AT 13% COST OF CAPITAL

Year	Cashflow	Discount factor 13%	PV CASHFLOW @13%
0	(2,000,000)
1	$180,000	0.885	$159,300
2	$240,000	0.783	$187,920
3	$280,000	0.693	$194,040
4	$300,000	0.613	$183,900
5	$520,000	0.543	$282,360
6	$480,000	0.480	$230,400
7	$530,000	0.425	$225,250
8	$585,000	0.376	$219,960
9	$590,000	0.33	$194,700
10	$592,000	0.295	$174,640
	Cumulative Cashflow		$2,052,470
	Less: Cashoutflow		$2,000,000
	NPV		$52,470

ohio project NPV

12%	$159,894
13%	$52,470

NPV of North Dakota @ 10%

10%

($30,349)

When cost of capital change from 12% to 13% for Ohio project and North Dakota Project is same, in both the projects

Ohio PROJECT will be selected as there NPV is positive