Capital budgeting practice problems.

1. Evaluation of Cash Flows. Below are the cash flows for two mutually exclusive
projects.
year CFX CFY
0 (5,000) (5,000)
!,0"5 0
! !,0"5 0
# !,0"5 0
$ !,0"5 %,&''
a. Calculate the pay(ac) for (oth projects.
(. *+itially, the cost of capital is u+certai+, so co+struct ,-. profiles for the two projects
(o+ the same /raph) to assist i+ the a+alysis. 0he profiles cross at what cost of capital1
2hat is the si/+ifica+ce of that1
c. *t is +ow 3etermi+e3 that the cost of capital for (oth projects is $4. 2hich project
shoul3 (e selecte31 2hy1
3. Calculate the 5*66 for (oth projects, usi+/ the $4 cost of capital.
7+swers8 a. !.$ yrs, $ yrs9 (. 049 c. X9 3. 5*66X : %.&%4
2. More practice with Cash Flow Evaluation. Cash flows for two mutually exclusive
projects are show+ (elow8
year CF5 CF,
0 (00) (00)
0 '0
! &0 50
# "0 !0
Both projects have a cost of capital of 04.
a. Calculate the pay(ac) for (oth projects.
(. Calculate the ,-. for (oth projects.
c. Calculate the *66 for (oth projects.
3. Calculate the 5*66 for (oth projects.
7+swers8 a. !.$ yrs, .& yrs9 (. ;".'", ;%.%"9 c. ".4, !#.5&49 3. &.54, &.%49
3. Expansion Proect. 7 machi+e has a cost of ;"0. *t will have a life of # years, a+3
will (e 3epreciate3 strai/ht li+e to <ero salva/e value. *t will result i+ sales reve+ue of
;!00 per year a+3 cash operati+/ costs of ;0 per year. =se of the machi+e will re>uire
a+ i+crease i+ wor)i+/ capital of ;'0 for the # years, (e/i++i+/ at year 0. 0he
appropriate 3iscou+t rate is "4 a+3 the firm?s tax rate is $04.
a. Calculate the i+itial cash flow at time 0.
(. Calculate the a++ual operati+/ cash flows (they are i3e+tical each year).
c. Calculate the releva+t termi+al cash flows at the e+3 of year #.
3. 2hat is the ,-. for the machi+e1
7+swers8 a. @!509 (. '"9 c. '09 3. ;&.5"
!. "nflation adustment8 7 project re>uires a+ i+itial i+vestme+t of ;",000, has a $@year
life a+3 provi3es expecte3 cash flows as follows, (ase3 o+ year prices a+3 costs8
a++ual reve+ue : ;5,000
a++ual cash operati+/ costs : ;!,000
a++ual 3epreciatio+ : ;!,000
termi+al cash flow : 0
cost of capital : $4
0 : #04
a. Calculate the a++ual operati+/ cash flows without a3justi+/ for i+flatio+. (7re these
cash flows real or +omi+al1) Calculate the associate3 ,-..
(. 73just the cash flows to reflect the effects of i+flatio+, which is expecte3 to affect sales
reve+ue a+3 cash operati+/ expe+ses at the rate of $4 a++ually. (7re these cash flows
real or +omi+al1) Calculate the associate3 ,-..
c. 2hich ,-. is the correct o+e for evaluati+/ the project1
a. @;##9 (. ;!0!
#. Mutuall$ Exclusive Proects with %ne&ual 'ives. 5urray?s Coffee Aouse is tryi+/
to choose (etwee+ two +ew coffee (ea+ roasters. 0he re>uire3 rate of retur+ for either
machi+e is 04. Bhow+ (elow are the after@tax cash flows associate3 with each
machi+e8
year CFX CFY
0 (50,000) (#0,000)
!0,000 !0,000
! !0,000 !0,000
# !0,000
$ !0,000
a. Calculate the replaceme+t chai+ ,-. for each project.
(. Calculate the e>uivale+t a++ual a++uity for each project.
c. 2hich project shoul3 (e selecte31 2hy1
7+swers8 a. 6C,-.X : ;#,#%', 6C,-.Y : ;",&0$9 (. C77X : ;$,!!&, C77Y : ;!,'$
(. )is* +dustment and Proect ,election. 7cme 5f/ is co+si3eri+/ two projects, 7 D
B, with cash flows as show+ (elow8
perio3 CF7 CFB
0 @50,000 @00,000
!0,000 &0,000
! !0,000 !5,000
# !0,000 !5,000
$ !0,000 !5,000
0he opportu+ity cost of capital for 7 is $ perce+t. 0he opportu+ity cost of capital for B is
0 perce+t.
a. Calculate the ,-. for each project.
(. Calculate the *66 for each project.
c. 2hich project(s) shoul3 (e accepte3 i+ each of the followi+/ situatio+s8
() 0he projects are mutually exclusive a+3 there is +o capital co+strai+t.
(!) 0he projects are i+3epe+3e+t a+3 there is +o capital co+strai+t.
(#) 0he projects are i+3epe+3e+t a+3 there is a total of ;00,000 of fi+a+ci+/ for
capital outlays i+ the comi+/ perio3.
3. Cxplai+ why the cost of capital for 7 mi/ht (e hi/her tha+ for B.
7+swers8 a. ,-.7 : ;",!'$, ,-.B : ;,0&59 (. *667 : !."&4, *66B : &.0"4
-. Cost of Capital. Eelta, *+c. has a stoc) price of ;50. *+ the fiscal year just e+3e3,
3ivi3e+3s were ;!.00. Car+i+/s per share a+3 3ivi3e+3s are expecte3 to i+crease at a+
a++ual rate of " perce+t. 0he ris)@free rate is $ perce+t, the mar)et ris) premium is &.$
perce+t a+3 the (eta o+ Eelta?s stoc) is .!5. Eelta?s tar/et capital structure is $04 3e(t
a+3 &04 commo+ e>uity. Eelta?s tax rate is $0 perce+t.
,ew commo+ stoc) ca+ (e sol3 to +et ;$0 per share after flotatio+ costs.
Eelta ca+ sell (o+3s that mature i+ !5 years with a par value of ;,000 a+3 a+ "4
coupo+ rate pai3 a++ually for ;%&0.
a. Calculate the (efore@tax i+terest rate o+ +ew 3e(t fi+a+ci+/.
(. Calculate the after@tax cost of 3e(t fi+a+ci+/.
c. Calculate the re>uire3 retur+ o+ the firm?s stoc) usi+/ C7-5.
3. Calculate the re>uire3 retur+ o+ the firm?s stoc) usi+/ the 3iscou+te3 cash flow
approach.
e. Calculate the cost of fi+a+ci+/ from the sale of commo+ stoc).
f. Calculate the 27CC if e>uity fi+a+ci+/ is from retai+e3 ear+i+/s.
/. Calculate the 27CC if e>uity fi+a+ci+/ is from the sale of commo+ stoc).
7+swers8 a. ".#%49 (. 5.0#49 c. !49 3. !.#49 e. #.$49 f. %.#49 /. 04
.. )eplacement proect/ Cxisti+/ machi+e was purchase3 ! years a/o at a cost of
;#,!00. *t is (ei+/ 3epreciate3 strai/ht li+e over its " year life. *t ca+ (e sol3 +ow for
;#,000 or use3 for & more years at which time it will (e sol3 for a+ estimate3 ;500. *t
provi3es reve+ue of ;5,000 a++ually a+3 cash operati+/ costs of ;!,000 a++ually.
7 replaceme+t machi+e ca+ (e purchase3 +ow for ;',"00. *t woul3 (e use3 for & years,
a+3 3epreciate3 strai/ht li+e. *t will result i+ a33itio+al sales reve+ue of ;,500 a++ually,
(ut (ecause of its i+crease3 efficie+cy it woul3 re3uce cash operati+/ costs (y ;&00 per
year. 0he +ew machi+e woul3 re>uire a33itio+al i+ve+tories of ;'00, a+3 accou+ts
receiva(le woul3 i+crease (y ;#00. *ts expecte3 salva/e value i+ & years is ;!,000.
0he tax rate is $04 a+3 the re>uire3 rate of retur+ is #4. Bhoul3 the ol3 machi+e (e
replace31
a. Calculate the i+creme+tal cash flow at time 0.
(. Calculate the i+creme+tal a++ual operati+/ cash flows that result from the +ew
machi+e.
c. Calculate the i+creme+tal termi+al cash flow.
3. Bhow the i+creme+tal CFs i+ the ta(le (elow.
Year Cash Flow
0 FFFFFFFF
FFFFFFFF
! FFFFFFFF
# FFFFFFFF
$ FFFFFFFF
e. Calculate the ,-. for this project.
7+swers8 a. G;&,0$09 (. ;,&!09 c. ,%009 e. ,#$%
0. Capital 1udgeting ,cenario +nal$sis
7cme 5f/. is co+si3eri+/ a project that re>uires i+itial i+vestme+t of ;%,&00 a+3 has a $@
year life. 7cme?s corporate wei/hte3 avera/e cost of capital (27CC) is 04.
0he pro(a(ility 3istri(utio+ of a++ual operati+/ cash flows (over its $@year life) is show+
(elow. 0here are +o other cash flows associate3 with the project.
Bce+ario pro( 7++ CF ,-. H that 7++ CF
2orst Case .# ;!,500 @;,&'5
5ost Ii)ely .$ #,000 @%0
Best Case .# $,000 ;#,0'%
a. Calculate the expecte3 ,-..
(. Calculate the sta+3ar3 3eviatio+ of ,-..
c. Calculate the coefficie+t of variatio+ (C.) of ,-..
7cme classifies projects i+to hi/h, avera/e, or low ris) accor3i+/ to the C. of ,-. as
show+ (elow8
C. ris)
Below ! low
Betwee+ ! a+3 # avera/e
7(ove # hi/h
0o 3etermi+e the ris)@a3juste3 3iscou+t rate (67E6) for each project, 7cme a33s or
su(tracts !4 to the corporate 27CC (ase3 o+ the C..
3. 2hat is the 67E6 for this project1
e. Calculate the expecte3 ,-. usi+/ the 67E6.
f. Bhoul3 the project (e accepte3 or rejecte31 Btate what your 3ecisio+ is (ase3 o+.
7+swers8 a. ;#"5.0"9 (. ;,"".&59 c. $."%9 e. @;#!.#5