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Problem Set 5
Chapter 11 -- Capital Budgeting
Assigned Problem 1
Winston Clinic is evaluating a project that costs $52,125 and has expected net cash flows of $12,000
per year for eight years. The first inflow occurs one year after the cost outflow, and the project has a
cost of capital of 12 percent.
a. What is the project's payback?
b. What is the project's NPV? Its IRR?
c. Is the project financially acceptable? Explain your answer.
ANSWER
a.
Table of cash flows for the project:
Annual
Cumulative
NPV
Year
Cash Flow
Cash Flow
Values
0
-$52,125
-$52,125
1
$12,000
-$40,125
$10,714
2
$12,000
-$28,125
$9,566
3
$12,000
-$16,125
$8,541
4
$12,000
-$4,125
$7,626
5
$12,000
$7,875
$6,809
6
$12,000
$19,875
$6,080
7
$12,000
$31,875
$5,428
8
$12,000
$43,875
$4,847
Payback
4.34
b.
NPV
$7,486.68 IRR
16%
c.
The project has a positive NPV and the IRR (16%) is greater than the cost of capital of (12%), therefore it is acceptable.
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B
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Problem Set 5
Chapter 11 -- Capital Budgeting
Assigned Problem 2
Great Lakes Clinic has been asked to provide exclusive healthcare services for next year's World
Exposition. Although flattered by the request, the clinic's managers want to conduct a financial
analysis of the project. There will be an up-front cost of $160,000 to get the clinic in operation. Then,
a net cash inflow of $1 million is expected from operations in each of the two years of the exposition.
However, the clinic has to pay the organizers of the exposition a fee for the marketing value of the
opportunity. This fee, which must be paid at the end of the second year, is $2 million.
a. What are the cash flows associated with the project that are relevant for capital budgeting purpose?
b. Find the project NPV if its cost of capital is 25 percent and if its cost of capital is 400%. Why would a financial calculator give an error message when attempting to calculate this project's IRR?
c. If the project cost capital is 10 percent, what would be the project's NPV in each case? Shoud the project be undertaken?
ANSWER
a.
Cash flows: Year
Cash Flow
0
-$160,000
1
$1,000,000
2
-$1,000,000
b.
NPV @
25%
$0 NPV @
400%
$0 c.
NPV @
10%
($77,355)
A
B
C
D
E
F
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Problem Set 5
Chapter 11 -- Capital Budgeting
Assigned Problem 3
California Health Center, a for-profit hospital, is evaluating the purchase of new diagnostic
equipment. The equipment, which costs $600,000, has an expected life of five years and an estimated
pretax salvage value of $200,000 at that time. The equipment is expected to be used 15 times a day
for 250 days a year for each year of the project's life. On average, each procedure is expected to
generate $80 in collections, which is net of bad debt losses and contractual allowances, in its first
year of use. Thus, net revenues for Year 1 are estimated at 15 x 250 x $80 = $300,000.
Labor and maintenance costs are expected to be $100,000 during the first year of operation, while
utilities will cost another $10,000 and cash overhead will increase by $5,000 in Year 1. The cost for
expendable supplies is expected to average $5 per procedure during the first year. All costs and
revenues, except depreciation, are expected to increase at a 5 percent inflation rate after the first year.
The equipment falls into the MACRS five-year class for tax depreciation and hence is subject to the
following depreciation allowances: Year
Allowance
1
0.2
2
0.32
3
0.19
4
0.12
5
0.11
6
0.06
The hospital's tax rate is 40 percent, and its corporate cost of capital is 10 percent.
a. Estimate the project's net cash flows over its five-year estimated life.
b. What are the project's NPV and IRR? (Assume that the project has average risk.)
A
B
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ANSWER
a.
Project's cash flows:
0
1
2
3
4
5
Equipment cost
$600,000
Net revenues
$300,000
Less:
Labor/maintenance costs
Utilities costs
Supplies
Incremental overhead
Depreciation
Operating income
Taxes
Net operating income
Plus: Depreciation
Plus: After-tax equipment salvage value*
Net cash flow
*
Pretax equipment salvage value
MACRS equipment salvage value
Difference
Taxes
After-tax equipment salvage value
b.
Spreadsheet solution:
NPV
IRR
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B
C
D
E
F
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Problem Set 5
Chapter 12 -- Project Risk Analysis
Assigned Problem 4
Heywood Diagnostic Enterprises is evaluating a project with the following net cash flows and
probabilities:
Year
Prob=0.2
Prob=0.6
Prob=0.2
0
-$100,000
-$100,000
-$100,000
1
$20,000
$30,000
$40,000
2
$20,000
$30,000
$40,000
3
$20,000
$30,000
$40,000
4
$20,000
$30,000
$40,000
5
$30,000
$40,000
$50,000
The Year 5 values include salvage value. Heywood's corporate cost of capital is 10 percent.
a. What is the project's expected (i.e., base case) NPV assuming average risk? (Hint: The base case net
cash flows are the expected cash flows in each year.)
b. What are the project's most likely, worst, and best case NPVs?
c. What is the project's expected NPV on the basis of the scenario analysis?
d. What is the project's standard deviation of NPV?
e. Furthermore, the company's policy is to adjust the corporate cost of capital up or down by 3 percentag
account for differential risk. Assume that Heywood's managers judge the project to have higher-than
Is the project financially attractive?
ANSWER
ge points to
n-average risk.
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Problem Set 5
Chapter 12 -- Project Risk Analysis
Assigned Problem 5
The managers of United Medtronics are evaluating the following four projects for the coming
budget period. The firm's corporate cost of capital is 14 percent.
Project
Cost
IRR
A
$15,000
17%
B
$15,000
16%
C
$12,000
15%
D
$20,000
13%
a. Assuming that all four projects have average risk, what is the firm's optimal capital budget?
b. Now, suppose Medtronic's managers want to consider differential risk in the capital budgeting
process. Project A has average risk, B has below-average risk, C has above-average risk, and D
has average risk. What is the firm's optimal capital budget when differential risk is considered?
(Hint: The firm's managers lower the IRR of high-risk projects by 3 percentage points and raise
the IRR of low-risk projects by the same amount.)
ANSWER
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Related Questions
Question 6
A project has expected cash inflows, starting with year 1, of $2,200, $2,900, $3,500 and finally in year four, $4,000. The profitability index is 1.14 and the discount rate is 12 percent. What is the initial cost of the project?
Group of answer choices
$9,211.06
$9,250.00
$8,166.19
$7,899.16
$8,098.24
arrow_forward
Question 4
Assume that you are analysing a capital budgeting project. The initial investment for buying machichnary
and equipment cost $5million and project will last for 5 year. The expected revenue is to be $2 million per
year and operating cost is expected to be 30% of the total revenue. If the salvage (scrap) value at the end
of 5 is estimated to be $0.50 million. You may use straight-line method to calculate the depreciation for
the project. The tax rate is estimated to be 30% per annum. The project has the cost of capital of 10%.
a. Calculate net cash flows for each year.
b.
Calculate the NPV and determine the payback period.
c.
Will you accept this project based on NPV? If the project payback policy is 4 years, will you
accept this project?
arrow_forward
Question 4: Capital Budgeting
a). Consider the following two mutually exclusive projects:
YEAR
0
CASH FLOW (A)
-$300,000
1
20,000
2
70,000
3
80,000
4
400,000
CASH FLOW (B)
-$39,000
18,000
12,000
18,000
19,000
Whichever project you choose, if any, you require a 15 percent return on your investment.
(i) If you apply the payback period (PBP) criterion, which investment will you choose?
Why?
(ii) If you apply the net present value (NPV) criterion, which investment will you choose?
Why?
(iii)If you apply the profitability index (PI) criterion, which investment will you choose?
Why?
(iv) If you apply the internal rate of return (IRR) criterion, which investment will you choose?
Why?
(v) Based on your answers in (i) through (iv), which project will you finally choose? Why?
Examiner: Prof. Ebenezer Bugri Anarfo
Page 9
b). You are trying to determine whether to expand your business by building a new
manufacturing plant. The plant has an installation cost of $15 million, which will be…
arrow_forward
QUESTION 3 - Capital budgeting Technique
You are considering two independent projects, Project A and Project B. The initial cash outlay
associated with project A is RM50,000 and the initial cash outlay associated with project B is
RM70,000. The required rate of return on both project is 12 percent. The expected annual free cash
flows from each project are as follows
Year
Project A
Project B
1
-RM50,000
-RM70,000
2
12,000
13,000
3
12,000
13,000
4
12,000
13,000
12,000
13,000
12,000
13,000
Calculate the NPV, PI, and IRR for each project and indicate if the project should be accepted.
arrow_forward
more.
3. Net present value method
Aa Aa
Consider the case of Underwood Manufacturing:
Underwood Manufacturing is evaluating a proposed capital budgeting project that will require an initial investment of
$120,000. The project is expected to generate the following net cash flows:
Year
Cash Flow
Year 1
$37,600
Year 2
$50,500
Year 3
$45,000
Year 4
$41,900
Assume the desired rate of return on a project of this type is 10%. What is the net present value of this project?
-$4,415.10
$18,344.79
-$7,244.50
$23,914.50
Suppose Underwood Manufacturing has enough capital to fund the project, and the project is not competing for
funding with other projects. Should Underwood Manufacturing accept or reject this project?
Accept the project
Reject the project
arrow_forward
which one is correct please confirm?
QUESTION 19
Whipple Industries Inc. is in the process of determining its optimal capital budget for next year. The following investment projects are under consideration:
Required
Expected Rate
Project
Investment
of Return
A
$2 million
20.0%
B
$3 million
15.0%
C
$1 million
13.5%
D
$4 million
13.0%
E
$1 million
12.5%
F
$3 million
12.0%
G
$5 million
11.5%
The firm's marginal cost of capital schedule is as follows:
Amount of
Funds Raised
Cost
$0 - $6 million
12.0%
$6 million - $12 million
12.5%
$12 million - $18 million
13.5%
Over $18 million
15.0%
Determine Whipple's optimal capital budget (in dollars) for the coming year.
a.
$5 million
b.
$10 million
c.
$14 million
d.
$11 million
arrow_forward
Problem 21
Compute the (1) net present value and (ii) discounted payback period of the following capital budgeting projects.
The firm's required rate of return is 12 percent.
Projects
Year
123
Zeta
$(50,000)
20,000
15,000
30,000
Omega
$(45,000)
42,000
9,000
1,850
Based on your calculations, which project will be selected if you have to choose only one of the two projects?
arrow_forward
Part 1
Please calculate the payback period, IRR, MIRR, NPV, and PI for the following two mutually exclusive projects. The required rate of return is 15% and the target payback is 4 years. Explain which project is preferable under each of the four capital budgeting methods mentioned above:
Table 1
Cash flows for two mutually exclusive projects
Year
Investment A
Investment B
0
-$5,000,000
-5,000,000
1
$1,500,000
$1,250,000
2
$1,500,000
$1,250,000
3
$1,500,000
$1,250,000
4
$1,500,000
$1,250,000
5
$1,500,000
$1,250,000
6
$1,500,000
$1,250,000
7
$2,000,000
$1,250,000
8
0
$1,600,000
Part 2
Please study the following capital budgeting project and then provide explanations for the questions outlined below:
You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago…
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General Account Subject
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- Question 6 A project has expected cash inflows, starting with year 1, of $2,200, $2,900, $3,500 and finally in year four, $4,000. The profitability index is 1.14 and the discount rate is 12 percent. What is the initial cost of the project? Group of answer choices $9,211.06 $9,250.00 $8,166.19 $7,899.16 $8,098.24arrow_forwardQuestion 4 Assume that you are analysing a capital budgeting project. The initial investment for buying machichnary and equipment cost $5million and project will last for 5 year. The expected revenue is to be $2 million per year and operating cost is expected to be 30% of the total revenue. If the salvage (scrap) value at the end of 5 is estimated to be $0.50 million. You may use straight-line method to calculate the depreciation for the project. The tax rate is estimated to be 30% per annum. The project has the cost of capital of 10%. a. Calculate net cash flows for each year. b. Calculate the NPV and determine the payback period. c. Will you accept this project based on NPV? If the project payback policy is 4 years, will you accept this project?arrow_forwardQuestion 4: Capital Budgeting a). Consider the following two mutually exclusive projects: YEAR 0 CASH FLOW (A) -$300,000 1 20,000 2 70,000 3 80,000 4 400,000 CASH FLOW (B) -$39,000 18,000 12,000 18,000 19,000 Whichever project you choose, if any, you require a 15 percent return on your investment. (i) If you apply the payback period (PBP) criterion, which investment will you choose? Why? (ii) If you apply the net present value (NPV) criterion, which investment will you choose? Why? (iii)If you apply the profitability index (PI) criterion, which investment will you choose? Why? (iv) If you apply the internal rate of return (IRR) criterion, which investment will you choose? Why? (v) Based on your answers in (i) through (iv), which project will you finally choose? Why? Examiner: Prof. Ebenezer Bugri Anarfo Page 9 b). You are trying to determine whether to expand your business by building a new manufacturing plant. The plant has an installation cost of $15 million, which will be…arrow_forward
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- Problem 21 Compute the (1) net present value and (ii) discounted payback period of the following capital budgeting projects. The firm's required rate of return is 12 percent. Projects Year 123 Zeta $(50,000) 20,000 15,000 30,000 Omega $(45,000) 42,000 9,000 1,850 Based on your calculations, which project will be selected if you have to choose only one of the two projects?arrow_forwardPart 1 Please calculate the payback period, IRR, MIRR, NPV, and PI for the following two mutually exclusive projects. The required rate of return is 15% and the target payback is 4 years. Explain which project is preferable under each of the four capital budgeting methods mentioned above: Table 1 Cash flows for two mutually exclusive projects Year Investment A Investment B 0 -$5,000,000 -5,000,000 1 $1,500,000 $1,250,000 2 $1,500,000 $1,250,000 3 $1,500,000 $1,250,000 4 $1,500,000 $1,250,000 5 $1,500,000 $1,250,000 6 $1,500,000 $1,250,000 7 $2,000,000 $1,250,000 8 0 $1,600,000 Part 2 Please study the following capital budgeting project and then provide explanations for the questions outlined below: You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago…arrow_forwardGeneral Account Subjectarrow_forward
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