Question

KEY TERMS Define the following terms: a. Capital budgeting; strategic business plan b. Net present value (NPV) c. Internal rate of return (IRR) d. NPV profile; crossover rate e. Mutually exclusive projects; independent projects f. Nonnormal cash flows; normal cash flows; multiple IRRS g. Modified internal rate of return (MIRR) h. Payback period; discounted payback CAPITAL BUDGETING CRITERIA You must analyze two projects, X and Y. Each project costs $10,000, and the firm's WACC is 12%. The expected cash flows are as follows: 2 3 Project X -$10,000 Project Y -$10,000 $6,500 $3,500 $3,000 $3,500 $3,000 $3,500 $1,000 $3,500 a. Calculate each project's NPV, IRR, MIRR, payback, and discounted payback. b. Which project(s) should be accepted if they are independent? c. Which project(s) should be accepted if they are mutually exclusive? d. How might a change in the WACC produce a conflict between the NPV and IRR rankings of the two projects? Would there be a conflict if WACC were 5%? (Hint: Plot the NPV profiles. The crossover rate is 6.21875%.) e. Why does the conflict exist?

Answer 1

a) Capital Budgeting is a process of planning related to long term investment or projects that requires a huge amount to be invested. These decisions involves like buying machinery or plant, building or any big project. A company evaluates that funds are worthy to invest in that project and which source of funding is better to raise funds so that company can earn higher returns than it will pay on funds raised.

Strategic business plan is such type of plan or strategy that is formulated to achieve overall goals set by a business. . It is formulated for future purpose where a business want to go or till that level business wants to flourish.

b) Net present value is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. It is also a method of capital budgeting and investment planning to analyze the profitability of a projected investment or project.

c) Internal Rate of return is a method of analysing profitability of a project by using the discount rate that makes the net present value of all cash flows (both positive and negative) equal to zero for a specific project or investment. A company will decide to either accept or reject a project on the basis of this method only.

d) NPV profile is a graphical presentation that shows the relationship between a project's NPV and the firm's cost of capital. The point where a project's net present value profile crosses the horizontal axis indicates a project's internal rate of return.

Crossover rate is that rate or percentage of cost of capital at which the net present values of two projects are equal. In this, NPV profile of one project crosses over (intersects) the NPV profile of the other project, so it is called crossover rate.

e) Mutually-exclusive projects are those set of projects out of which only one project can be selected for investment because decision to undertake one project from mutually exclusive projects effects other projects as well.

Independent projects are projects that are not related to each other and each project is evaluated based on its own profitability. Acceptance and rejection of one project is independent of other.

f) Non-normal cash is a pattern of cash flows in which the direction of cash flows keeps changing. It is also known as unconventional cash flow.

In Normal cash flows, cash flows does not keep on changing frequently and comprises initial investment outlay and then positive net cash flow throughout the project life. It is also called conventional cash flow stream.

Multiple IRRs means a project having more than one internal rate of return and it arises when a project has non-normal cash flow patterns.

g) Modified internal rate of return (MIRR) is modified from of the internal rate of return (IRR) and resolves problems with the IRR and it is used in capital budgeting to rank alternative investments of equal size.

h) Payback period refers to the amount of time required to recover the cost of an investment. Simply it tells the length of time which is needed to cover a project's initial cost.

ANS. 2

a)

Net Present Value = Total cash outflows – Present value of Cash inflows

Present Value of Cash inflows = Cash inflow / ((1+d)^n)

d = discount rate,

n = the number of periods

For projectX:

Net Present Value = 10000 - (6500/1+12%)^1 + (3000/1+12%)^2 +(3000/1+12%)^3+(1000/1+12%)^4

= 10,000 – (5803.57+2391.58+2135.34+635.52)

= 966.02

For Project Y

Net Present Value = 10000 - (3500/1+12%)^1 + (3500/1+12%)^2 +(3500/1+12%)^3+(3500/1+12%)^4

= 10,000 – (3125.00+2790.18+2491.23+2224.31)

= 630.72

2. Internal Rate of return

Using trial and error method:

The discount rate is 18% for Project X

10,000 = (6500/(1.18)^1) + (3000/(1.18)^2) +(3000/(1.18)^3)+(1000/(1.18)^4)

10000 = 10004

Project Y = 15%

10,000 = (3500/(1.15)^1) + (3500/(1.15)^2) +(3500/(1.15)^3)+(3500/(1.15)^4)

10000 = 10000

3. Modified Internal Rate of Return

For Project X

Cost = Summation of Cash inflows (1+r)^n-t/(1+MIRR)^n

10000 = (6500/(1.12)^3) + (3000/(1.12)^2) +(3000/(1.12)^1)+(1000/(1.12)^0 / (1+MIRR)^4

10000 = 17375.23/(1+MIRR)^4

(1+MIRR)^4 = 17375.23/10000

(1+MIRR)^4 = 1.737523

= MIRR = (1.737523^1/4 ) – 1.0

=0.1481 = 14.81%

For Project Y:

Cost = Summation of Cash inflows(1+r)^n-t / (1+MIRR)^n

10000 = (3500/(1.12)^3) + (3500/(1.12)^2) +(3500/(1.12)^1)+(3500/(1.12)^0 / (1+MIRR)^4

10000 = 16727.65 /(1+MIRR)^n

(1+MIRR)^4 = 16727.65/10000

(1+MIRR)^4 = 1.6727.65

MIRR = (1.672765^1/4 ) – 1.0

0.1373 = 13.73%

Payback period of X = 6500 + 3000 = 9500

now, remaining 500 = 500/3000 = 0.16

So, payback period = 2 year + .16 = 2.16 years

Payback period of Y: 10000 / 3500 = 2.85. Years

B)

Both Projects can be accepted if they are independent as both are giving good returns and returns are higher than WACC of the projects.

C)

PROJECT X should be accepted if projects are mutually exclusive as Project X is yielding higher returns in each method whether it is NPV, IRR or MIRR  than Project Y and these methods are considered crucial in taking decisions.