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**Case: Capital Budgeting
**

Corporate Financial Decision

Submitted to:

Prof. Dr. Radhe S. Pradhan, Ph.D.

Ace Institute of Management

New Baneshwor

Submitted by:

Sachindra Pradhanga

Sagar Nath Upadhyaya

Serish Dhital

Sudeep Bir Tuladhar

Sushil Bajimaya

Chandika Amgain

EMBA, Fall 2011

Contents

Background ..................................................................................................................................... 1

Projects ........................................................................................................................................ 1

Project A: Major Plant Expansion .......................................................................................... 1

Project B: Alternative Plan for Plant Expansion..................................................................... 1

Project C: Purchase of New Press ........................................................................................... 2

Project D: Upgrade of Egret’s Video Text Service ................................................................ 2

Question 1 ....................................................................................................................................... 3

Payback, NPV, IRR Determination ........................................................................................ 3

Project Ranking ....................................................................................................................... 3

Project Selection ..................................................................................................................... 4

Appropriate Discount Rate ..................................................................................................... 4

Question 2 ....................................................................................................................................... 7

Calculation of Equivalent Annual Annuity (EAA) for each project....................................... 8

Question 3 ..................................................................................................................................... 10

Question 4 ..................................................................................................................................... 13

Question 5 ..................................................................................................................................... 20

Question 6 ..................................................................................................................................... 22

Question 7 ..................................................................................................................................... 24

Question 8 ..................................................................................................................................... 27

Question 9 ..................................................................................................................................... 29

Question 10 ................................................................................................................................... 31

Annex ............................................................................................................................................ 32

Calculation of Payback Period .................................................................................................. 32

Project A ............................................................................................................................... 32

Project B................................................................................................................................ 32

Project C................................................................................................................................ 32

Project D ............................................................................................................................... 33

Discounted Payback Period for Project A ............................................................................ 33

Project B................................................................................................................................ 34

Project D ............................................................................................................................... 35

Net Present Value ..................................................................................................................... 36

IRR (Internal Rate of Return) ................................................................................................... 36

Project B................................................................................................................................ 36

Project C................................................................................................................................ 37

Project D ............................................................................................................................... 37

Background

Egret Printing and Publishing Company is a family owned speciality printing business founded

by John and Keith Belford in 1956 after they were retired from the US Army. Patrick Hill, Keith

Belford’s son in law, joined the firm in 1979 in the Accounting Department and was promoted as

a treasurer in 1988 and then as the Vice-President of Finance in 1994. Hill has the responsibility

for both external and internal financial operations, but mostly it is internal. John and Keith

Belford were reluctant about long term debt financing their business because they were aware of

the difficulties their father faced during the Great Depression. However, Hill doesn’t agree with

this philosophy and feels that all equity capital structure is conservative.

The term capital budgeting refers to the process of decision making by which firms evaluate the

purchase of major fixed assets, including building, machineries, and equipment. Capital

budgeting describes the firm’s formal planning process for the acquisition and investment of

capital and results in capital budget that is the firm’s formal plan for the expenditure of money to

purchase new fixed asset for expansion or replacement of business.

Hill is presently occupied with detailed analysis of four major capital investment proposals that

the Belfords have identified as possible candidates for funding in the coming year. A description

of each of the four projects is also given that includes information such as the costs and expected

after-tax cash flows (net income plus depreciation). The four projects are considered to be

equally risky and their risk is about the same as that of the company’s other assets.

Projects

Project A: Major Plant Expansion

This project is designed to alleviate the capacity problem by constructing a new wing on the

main plant. This additional space would allow to hold a greater variety of paper stock in

inventory and to reposition its various processes for a more efficient work flow.

Project B: Alternative Plan for Plant Expansion

This project is an alternative of project A. It can be installed much more quickly and will allow

Egret to take several major printing jobs in the next few years.

So. Project D: Upgrade of Egret’s Video Text Service This is independent project toward video test service in which the firm has made investment since 1991 and because the number of existing as well as new subscribers has fallen. it is inherent to invest in this project. the existence of this project will not affect the future cash flow for project A or B.Project C: Purchase of New Press This is a dependence project on A or B. It is basically for covering the extra market of high quality color calendar demanders. .

0959 1.60 26.857931 2.148675 3.881595 2. Which projects should the company choose and why? (Note: Projects A and B are mutually exclusive). net present value and the internal rate of return for each project.447.167. Net Present Value and Internal rate of return for all four projects are as follows: Projects PP DPP@15% DPP@21% NPV@15%($) NPV@21%($) IRR A 3.00 34.7 29.678977 141.480.8571 3.Question 1 Determine the Payback.62227 B 1.534.50 22.068357 625.409.40 70.980313 4. IRR Determination Payback period.032. .99251 C 3. rank the investment proposals considering the capital budget of $ 1. NPV is for ranking the projects because of the following reasons: It takes into account all cash flows. Payback.720. NPV.530375 3.481481 1. using both 15 and 21 percent discount rates.60 309. All cash flows are discounted at the appropriate market-determined opportunity cost of capital.94826 D 2. The projects are ranked on the basis of their NPV values.70 100.755012 166. NPV of a project is exactly the same as the increase in shareholders’ wealth as can be seen from below: Pay off all interest payments to creditors.1122 159.10892 Project Ranking Rank NPV@15% 1 C 2 A 3 B 4 D For detailed calculations.00 12. please refer the annex.5 million.400.

000 $784. 15% is more appropriate percentage for discounting.647.927. then company should choose the combination of projects B and C. If the discount rate is 21%.7 5 $112.500. .3 2 B and C 1.7 1 C and D 1.2 3 A and D 1.753.500.943. then the company should choose the combination of projects A and C.566. Appropriate Discount Rate Since the net present value at 15% discount rate is higher than that of 21%.5 4 If the discount rate is 15%.4 4 $82. Pay off the original investment.500.00 1 $380. net present values and internal rates of return for all of the projects are compared with each other in the following graphs.000 $791.3 2 $409.000.000 $766. Comparison of Different Projects Payback period.848. The NPV of combination give highest value compared to others.000 $300.000 $307. Pay off all expected returns to shareholders.6 3 $321. discounted payback period.000. The combination C and D is not feasible because project C cannot be implemented if both projects A and B are rejected.568.130.1 5 B and D 1. Project Selection Project Combination Required Investment NPV@15% Rank NPV@ 21% Rank A and C 1.442.880.

Figure 1: Comparison of NPV of different projects Figure 2: Comparison of payback period .

40 35 30 25 Project A Project B 20 Project C 15 Project D 10 5 0 IRR Figure 3: Comparison of IRR of all the projects .

They may give different indications about the projects financial characteristics. or receipts. Since payback period is easy to calculate it is being widely used. discounted at the cost of capital. NPV is considered feasible only if the firm knows the cost of capital or discounted factor. Ignores cash flows occurring after the payback period. which projects should Egret Printing and Publishing Company accept for the coming year and why? Payback Period is the number of years required to recover the initial capital expenditure on a project. if cash are equal or even. it is difficult to understand as there may be two experimental rates because of unequal present value of cash inflow with present value of cash outflow. Project choice based on Payback. The main drawback of IRR is. But it has some limitations like: It does not consider time value of money. it is not capable to measure profitability. Moreover the decision on different age of projects can’t be sufficed by calculating NPV without taking consideration of project life. If IRR is greater than cost of capital we accept the project else we reject it. to the initial cost outlay.Question 2 Do you find anything wrong in choosing the projects based on payback. but certainly not a definitive answer that an investor can rely on for all investment decisions. Net Present Value (NPV) requires finding the present value of the expected net cash flows of an investment. Payback period is also the ratio of Original Investment to Annual cash flow having condition. which may not be the current cost existing in the market. and subtracting from it the initial cost outlay of the project. Due to some of these limitations the firm cannot fully rely on this method only for choosing among the projects. it is not helpful for comparing two mutually exclusive investments and comparing two projects. NPV and IRR as stated above? What suggestions can be made to the company? How should the projects with unequal lives be dealt with? Determine the equivalent annual annuity (EAA) for each project and based on the calculations. NPV and IRR are not always consistent. NPV is a useful starting point to value investments. Internal Rate of Return (IRR) is the interest rate that equates the present value of the expected future cash flows. The reason for this potential problem is the timing of the cash flows of the mutually .

043.489.exclusive projects. 4years A 4 164.562.00 122.00 54.00 4.00 25.39 71.969. Project with unequal lives can be dealt with two methods they are: 1. Replacement-chain method: In this approach the projects under the evaluation are made by making the lives of the project common or equal lives.137.775.2 Project C 122006. But we should equally take care on whether the given annual return can be replicated by short life projects in the same way.088.06 Particulars EAA @15% EAA @21% Project A 57645.92 Project B 54654.178. Calculation of Equivalent Annual Annuity (EAA) for each project Project Years NPV@15% NPV @ 21% PMT= NPV/PVIFA15%.00 76.60 27. EAA will give the average annual return that each project will provide.39 27969.39 Project D 25887.87 76489.225. there is a need to adjust for the timing issue in order to correct this problem. 4years PMT= NPV/PVIFA21%.577.29 39562.39 D 5 86. As a result.645.60 57. The project having the highest EAA should be chosen as higher EAA is associated with higher NPV.20 C 10 621.488.887.654.92 B 4 156.00 39.006. Equivalent annual annuity: in this approach the constant annual annuity is calculated for the projects that has the same NPV as that calculated in the projects.29 100. The company can be suggested to calculate the Equivalent Annual Annuity (EAA) by eliminating the effect of the life of the project.038.53 4178. 2.53 2. So comparing the same annual return is realistic.87 310.06 .

652.40 3 $80.Project EAA @ 15% Rank EAA at 21% Rank Combination A and C $179.147.667.541.740.31 2 B and C $176. .82 5 $43.16 2 $116.459.26 1 $104.59 1 C and D $147.26 4 Hence from the above calculation we can conclude that: at 15% A and C’s combination is the best and at 21% B and C’s combination is the best as both combination has highest EAA achieved.45 3 A and D $83.98 5 B and D $80.894.532.92 4 $32.051.661.

35 PV @30% -500.51 0.000 1 370. Which Project appears to be superior? Why? Calculation for the Graph Project A Project A -500.000 1 270.364 0.744 298.380 89.000 136.000 104.683 PV @ 10% -500.(CF (CF) ) -500000 0 370000 234000 270000 -134000 PVIF @ 20% 1 0.800 PVIF @0% 1 1 1 1 1 PV @ 0% -500.592 0.020 116.000 264.714 0.210 187.840 0.455 0. in part.51 0.000 336.512 61.751 0.800 526.862 PV 0 -201708 PVIF@17 % 1 0.000 618.624 112.288 94.592 159.694 0.694 0.7431 -99575.467 209.000 Calculation of Crossover rate Project PVIF B @0% -500.4 PVIF @ 20% 1 0.000 113.833 0.045 PVIF@16 % 1 -0.180 137.579 0.700 56.000 618.909 0.364 0.420 12.530 0.330 223.35 17.751 49.000 1 370.150 0.360 49.769 284.000 136.000 136.618 108.000 1 155.000 136.384 78.000 308.000 123. your answers for the IRR and NPV in Question 1.000 136.880 216.8547 0.7305 PV @ 40% -500.826 155.909 270.833 0.579 0.580 -36.26 PV @ 40% -500.4 0.6 84677.800 PVIF @ 10% 1 0.222 Project B Diff.444 PVIF @ 40% 1 0.714 0.000 136.000 1 0.584 80.525 0.826 0.640.455 70.8 -97887 .000 1 Year 0 1 project A (CF) -500000 136000 2 136000 PV @ 10% -500.736.888 -123.953 PVIF PVIF @ PV @ 30% @30% 40% 1 -500.4 260.000 0.769 0.000 0.482 PV @ 20% -500.482 PV @ 20% -500.6 PVIF @ 30% 1 0.26 32.504 160.960 PV 0 199999.261.405 33.740 -28.000 1 49. Also determine the crossover rate by following the computational procedure.104 69.136 422.144 Project B PVIF PV @ @ 0% 10% -500.000 0.Question 3 Draw the graph of NPV versus discount rate for projects A and B (a present value profile) using.745 23.336 102.000 0.000 97.683 344.

5336 -11861.6243 0. Project A is better whereas above the crossover rate. Strictly from quantitative view.5 4 1243.e. In this case. It means both the project have same NPV i. Project B is relatively stable.6407 0. The relative stability of NPV of project B over project A may be added factor that will provide us qualitative reason to choose project B at some rate below crossover rate. The conflict only arises in .7 304045. Project B is our obvious choice because the required rate is 21 % which is above crossover rate where NPV is higher for project B than project A.3 4 136000 618800 155000 49000 -19000 569800 0.84 0. Project B is better in terms of NPV. below the crossover rate. 144320 at this rate.3 314700.17 %.22 The crossover chart shows the crossover rate is 16.2 8 -5703. Not only this. Therefore the fluctuation on WACC will also have less impact on the Project B whereas project A is highly sensitive.5523 -12173. It is because the significant portion of cash inflow of project B occurs at the beginning years whereas the highest cash flow of project A occurs at the end of year 4. IRR also supports project B but IRR is not a sole determinant in the decision to select project B and it is NPV that matters most.

. Otherwise project B is best. In that case we may choose project A if there is certainty that the required rate will not cross the crossover rate significantly during the project life.choosing project if the required rate drops below crossover rate.

000 195.000 195.000 1 -500.000 195. Would this situation bear on the decision about the mutually exclusive projects? Explain.835 .000 195.Question 4 Now suppose that Hill made a mistake in the projected cash flows for Project D – they should have been $195.000 0.000 0.000 -110. Project D After correction in Cash Flows a) Ordinary Payback Period Original Investment Year 1 Year 2 Year 3 Year 4 Year 5 Cash Flows Cumulative Cash Flows -500.000 per year.000 Payback Period = (500.497 96.87 169.350 195.930 195.000 195.000 -500.650 -330.572 111.000 195.420 -182.915 153.000) = 2.000 0.000 200.000 375.658 128.000 0.920 195.000 85.620 195.56 years b) Discounted Payback Period Project D @ 15% discount rate: Year 0 1 2 3 4 5 Cash Flows PVIF@15% PV Cumulative CFs -500.000 0.000 -305.310 -54.756 147. Determine the effect of this change would have on capital budgeting.000/195.835 NPV 153.540 56.000 -500.

000 0.270 70.000 0.386 75.000 -500.270) = 4.565 110.000 195.745 195.065 -4.540) = 3.05 years .930 195.765 NPV 70.000 0.620/111.467 91.765 Discounted Payback Period = 4 + (4.070 -338.683 133.505/75.Discounted Payback Period = 3 + (54.505 195.826 161.000 0.185 -205.175 -95.000 0.000 1 -500.570 195.48 years Project D @ 21% discount rate: Year 0 1 2 3 4 5 Cash Flows PVIF@21% PV Cumulative CFs -500.

000 -500.36 Changes on Project D.000 each year) Project D (cash flow of Rs.86 86.25 4.490/ (3.000 195.490 CFs PVIF @ 28% PV Cumulative CFs -500.015 -135.765 27.36 = 27.000 0.54 Result Decrease in payback period Increase in NPV Increase in IRR Decrease in discounted payback 4.000 0.755 195.62 120.000 0.56 153.77 .000 0.635 195.000 195.05 0.000 0.36 0.000 0.085 3.465 -346.000 0.705 195.00 -5.48 0.060.82 4.61 118.740 195.775 12.11 2.373 72.000 1 -500.595 195.950 -228.535 195.000 0.900 -225.NPV of HR)}* (HR–LR) = 27% + {3.3 -67.000 -500.787 153.880 -55.260 NPV -6.735 -63.175.303 59.540.745 -6.384 74.000 0. after correction in cash flows Criterion Ordinary Payback period NPV @ 15 % NPV @ 21% IRR Discounted payback period @ 15% Discounted payback period @ 21% Project D (cash flow of Rs.225 22. 195.00 -58.490+6260)}* (28-27) = 27% + 0.490 NPV 3.000 1 -500.835 70.295 -347.260 IRR = Lower Rate + {NPV of LR / (NPV of LR .02 3.005 195.488 95.781 152.291 56.000 each year) Changes 2.475 195.000 0.477 93.160 -130.c) IRR Year 0 1 2 3 4 5 Year 0 1 2 3 4 5 CFs PVIF @ 27% PV Cumulative CFs -500.

000.00 195.46%.00 $164.00 195.000. The new debt of $500.000.48 years Discounted payback period @ 21% 3.488 $310.00 136.5 million.56 years Discounted payback period @ 15% 3. .000.000.000 to $195.000.775 to $153.000.000.000.835 $71.15 years 1.00 195.1 years 2. due to the constraints of the capital budget.000.61% 35.835 when the annual cash flow changed from $175.60 $156.043.000.00 370000 323. however. the IRR of the project has also increased from 22.00 155000 323.050 to $70.00 195.00 136.11 years 5.000. the company would have to acquire a long-term debt of $500. the NPV of this project increased from $12.00 195.570. the selection of Project D cannot be considered since Project A and Project C has been recommended which adds up to the available budget of $1.00 -500000 -1.000. With the changed cash flow of Project D.02% 29.000 for Project D.54 years 1.53 years 4.00 323.000.137 $153.000.00 323. In order to select Project D.94% 27.000.000.00 618.00 323.000.577. Similarly.16% to 27.36% 3.800.60 $100. would not make any difference to the mutually exclusive projects. IRR and payback periods all imply that Project D is feasible.75 years 2.00 323.00 136.000.765 26. the payback periods at both discounting rates of 15% and 21% have also decreased slightly.000.00 323.000.00 -500.05 years Above calculation shows that NPV of Project D increased from $86. When the discount rate is 21%.00 323.87 years 4. The calculation of NPV.Comparison of Different Projects Year 0 1 2 3 4 5 6 7 8 9 10 NPV @ 15% NPV @ 21% IRR Payback period Project A Project B Project C Project D -500.48 years 3. However.088 $70.038 $621.000 when the discount rate is 15%.48 years 3.000.00 49000 323.00 270000 323.000.

000 160.175.000 each year) 5.000 each year) 100.000 each year) 60. after changes in Cash Flows .00 Payback IRR Discounted Discounted payback period payback period @ 15% @ 21% Comparison of Payback Period (years).000 40.000 each year) 10.000 Project D (cash flow of Rs.Changes on Project D.00 15. IRR (%) and Discounted payback period at different rates of Project D.000 20.000 140. after changes in Cash Flows 180.00 Project D (cash flow of Rs.000 Project D (cash flow of Rs.00 Project D (cash flow of Rs.00 25. 195.00 20. 195.000 80. after correction in class flows 30.175.000 120.000 NPV @ 15 % NPV @ 21% Comparison of NPV at different rates of Project D.

175.000) 200000 100000 0 NPV @ 15% NPV @ 21% Comparison of NPV at different rates of all the projects. before and after changes in Cash Flows of Project D 40 35 30 Project A 25 Project B 20 Project C 15 Project D (Rs.Comparison of Different Projects – (after change in Cash Flows of Project D) 700000 600000 500000 Project A 400000 Project B Project C 300000 Project D (Rs. 195. 175.000) 5 0 IRR Comparison of IRR of all the projects.000) Project D (Rs. 195.000) 10 Project D (Rs. before and after changes in Cash Flows of Project D .

000) 2 Project D (Rs. 175.Comparison of Different Projects – (after change in Cash Flows of Project D) 6 5 4 Project A Project B 3 Project C Project D (Rs. before and after changes in Cash Flows of Project D . 195.000) 1 0 Payback period Discounted payback period @ 15% Discounted payback period @ 21% Comparison of Payback period and discounted payback period at different rates of all the projects.

the IRR of project B is 35%.00 2.439. would it be reasonable for Hill to claim that project B will generate a return of approximately 35 percent over its four year life? Explain in terms of available reinvestment rates. we get PVIF 35% Present Value of Terminal Cash Inflow Present Value of Outflow NPV @ PV @ 35% $1.655.497. Similarly.4096 $589.00 1 Terminal Value of Cash Inflows FV of Inflows $757. Calculation of MIRR: For Project B Year 1 2 3 4 Cash Inflows FVIF @ 27% $370.00 1.204 0.000 $89. Since project A’s IRR is equal to reinvestment rate.Question 5 Assuming that the return on Project A is representative of the investment opportunitities generally found on the printing industry. Trying at 35% and 25%.96 .00 $435.000.27 $49. We Know that the Internal Rate of Return (IRR) is the discounting factor that makes the NPV of the project zero.483.00 $1.96+66.0483 $270.000. In this case the IRR of project A is approximately 27%.96/ (89497.497.204.00 MIRR is calculated to determine the rate at which the present value of a project’s outflow equals the terminal value of the project’s inflows.000 ($66.000. reinvestment rate would be 27% as well.439.000.6129 $155.3011 $433. Hence the representative of investment opportunities for printing industry is only 27% which is much lower than 35% it would not be reasonable to claim that Project B will generate a return of approximately 35% over four year life.871.850.344.96 1 $500.00 $49.00 1.655.00 $196.68) * (35-25) PVIF @ 25% PV@ 25% 0.68) MIRR= 25% + 89.000.32 $500.497.000 1 $500.

project B will generate return around 30.73% at reinvestment rate of around 27%. Therefore.= 30. MIRR of the project B is 30. it can be concluded that for reinvestment of around 27%.73% As we can see in the above calculation.73% .

If Belford Brothers are convinced to opt for a debt financing of $500.5million to $2million. But the company should be open to change if the facts and figures are in favour. but the marginal cost of this extra capital is 21% rather than 15% cost of internal funds. but relatively doubtful that he will be able to persuade the Belford brothers to employ debt financing.5million that will be generated internally are available. Though Belford brothers have resisted the attempts to convince them to use debt. Patrick Hill has done his homework.25 6.000 at the rate of 12%.48% 0 0 0.87% .75 15% Weighted average cost of capital Weighted Cost 1.500. The company is reluctant to modify its financing style due to some bad experience in the past. Funds over and above the $1.000 Calculation of kdt: Interest rate of debt (kd) = 12% Weight After tax cost 0. they are always willing to listen to new arguments on the subject. Could there ever be a situaltion in which project D is advisable? Explain. Egret Printing and Publishing Company has stuck to an extremely conservative approach of capital structure by adapting all equity capital.Question 6 If Hill is confident that he will be a ble to generate more and better projects in the years to come. The cost of equity capital is 15% for the capital budget of $1. Hill has come to a conclusion that their opportunity cost on outside investments is 21%. He has discussed with the bank about debt financing and has got an assurance of $500. So if debt financing generates higher returns then the company should be open to it as well.62% 0 11. Then the new capital structure will be: Type of capital Long term debt Preferred stock Common equity Amount ($) 500.000 then the total capital of the company will increase from $1.000 0 1.25% 12. how might this influence his recommendation. From the discussions with Belfords.5 million.

75 This shows that the weighted average cost of capital has decreased from 15% to 12.000.000.48% Where. Weight of debt = 500.000 /2.000.46) = 6. So project D is advisable in this scenario. Also the increase in capital will allow the company to undertake an additional project.87%. .After tax cost of debt (kdt) = kd*(1-tax rate) = 12*(1-0.000 /2.25 Weight of equity= 1500. Projects A and Project B are purposed as alternatives and we have recommended one of them so the next option is project D with a total investment of $500.000= 0.000 =0.

242.333 4 0.000 -500.826.31.756 286.496 327.000 debt at 12% interest rate.74.616 618.820.810. they will use $500.91.695 136.000 176.) If Belford’s agree to Hills proposal to use debt financing.628 136.000 -500.107 7 0.000 175. Calculation of the new cost of capital with their respective financial source weights is already shown in the previous section.93 155.000 120.484 323.6643 TPV of Inflows 703.000 108.785 3 Yr.2419 6 0.000 370. the company has now.000 323.000 381. $ 2 million to invest in the projects and can choose three projects.703.87%.Question 7 If the Belfords agree to Hill’s proposal to use a modest amount of debt to finance the projects this year.218.000 175.000 270. we can choose either (A.415 761.546 323.511 10 0.000 155.08 177.000 175.000 96.000 323.820 617. what would be its implication on the present capital structure and the cost of capital? In terms of the future returns to the Belfords families.629.073.472. C & D) or (B.967 253.552 0.87 -500.581 121.113 5 0.000 138.868 NPV 203.428 323.073.000.016.000 175.381 224.08 677.68 301.000 2 0. From the investment of 2. 0 1 1 Cash Flow(A) Cash Flow(C) Cash Flow(D) PV(A) PV(B) PV(C) PV(D) -1.641.197 107.000 945.472.000 175.936.38 323.733.623.405. So.794.800 49.4 107.378 955.000 122.253.408 137.298 323.000 106.415 1.000 156.761.336 323.000.733.000 323.000.673 9 0. C & D) since Project A and Project B are presented as alternatives in the case.000 323.000 -500.886 136. PVIF @12.000 0.000 -1.169.000 -500.323.34 8 0. Now.760 211.868 .045.79 117.366. This gave the weighted average cost of capital to be 12.000 we can select three projects.3116 199.000 Cash Flow(B) 500. what would be the impactfrom using this debt financing or what would be the extra value addition in the present values of the selected projects? (Revise your computations using a new discount rate and conclude about the projects to be chosen.539.

So.07 Profitability Index(PI) 1.366.568.167. C & D = NPV of Projects (B + C +D) = $(177733.Net present value of project A.08+ 761.868) =$ 1.082.082.74 $791. C & D Initial Investment 2 million 2 million NPV 1. this was selected as the best combination.057.52 From this table we can select projects A.415+ 761820.54 1. C and D when the company takes the debt financing with 12.057.027.366.74 3.74 . C & D = NPV of Projects (A + C +D) = $(203.472.400.00 The impact of using this debt financing is shown by the extra value addition in present values of selected project: Particulars Net present value of selected projects after inclusion of debt in capital structure Less: Net present value of selected projects before inclusion of debt in capital structure.87% B.366.738 Net present value of project B. Also. there was internal financing through retained earnings and excluded external financing through debt.798.87% cost of capital.79+ 117472. the combined NPV of project A& C reveals higher value.082.07 PV of Inflow 3.820.87% A.79+ 117.082.073 Profitability Index of Projects: Combination Discount rate of Projects 12.868) =$ 1.60) =$791.027.073.40+625.027. When 15% cost of capital was taken as discounting factor. Extra value additional due to use of debt financing Amount $1.057.366.568 $290.74 1. With all Equity financing at 15% cost of Capital: Net present value of project A & C = NPV of Projects (A + C) = $(166. C & D 12.

Debt financing is relatively cheaper financing method as the company can utilize capital with lower rate. Therefore. instead of using the combination of projects A & C. . the combination of A. C & D should be selected considering the profitability index which is calculated on the basis of NPV and Total PV of inflows.This shows that when debt financing is used the company can yield more NPV as debt financing helps to leverage the capital structure.

333. Calculation of Net Profit: Particulars Dividend Retained Earning Net Profit Amount 300.333.5 million of internal funds available to finance new investment is after paying a dividend of $300.800. This represents a very healthy ratio.55 with use of $500.33 60.000 Calculation of EBIT: Particulars EBIT Less: Interest EBT Less: Tax @ 46% Net Profit Amount 3.333.33 1.500.000 of debt to increase the risk to the Belfords by very much? Explain by considering times interest earned ratio.800.000 1.333. The reason behind this high interest earned ratio is low amount of debt capital used by the .000 will yield interest earned ration of 56.533.33 1.000 Thus it is seen that the internal funds of $1. do you consider the use of $500.000 3.Question 8 Assuming that the $1.000 and represents an average addition to retained earnings.393.5 million after paying a dividend of $300.000 of debt.000 1.

Hence it is clear that the use of $500.000 of debt will not increase the risk to the Belfords very much. .company and only a small portion of EBIT will be required to pay the interest expense.

all the projects could have been . project C has reduced the alternatives. Hence the number of options to rank should have been 5 and they are: project A. The way project C is handled is not very logical we already know that project C is dependent on acceptance of project A or B.500.000. This would take the total investment to $2 million which requires debt and the firm is not in a position to use the debt capital. for C to be implemented. Once the new equipment and press is bought. Basically projects A and B are related to alleviating capacity problem by expansion of the plant where as project C is related to purchase of new printing equipment and press. project A&C. the ranking of the projects also has been affected by the dependency of project C. It will be very convenient and logical if we can take dependent projects as a single alternative and deal as a joint project like projects A & C and projects B& C should have been treated as single projects. project A and B are independent upon C whereas project C is dependent on either of them. Another implication is that a project combination of C and D could never be used.Question 9 The case stated that Project C would be feasible unless either Project A or Project B was also accepted. project C does not have any side effect on viability and profitability of project A and project B. Moreover. project B&C and project D. however. Although a project combination of C and D requires $1. What is the implication of this statement on the current capital budgeting analysis? Do you think that the way Project C is handled earlier in the case valid? Why or why not? As mentioned in the case. Had there not been any dependent project among the alternatives. Hence. further $500. It has made the combination of project C and project D as unfeasible alternative.000 needs to be invested in either Project A or B. Moreover. it will require additional space to function. Due to its dependency. Therefore the feasibility of project C is very much dependent on acceptance of either project A or project B. So project A and B provides the basis required for project C to be implemented. projects A and B are mutually exclusive so that either of this project can be chosen at one particular time whereas project C cannot be feasible unless projects A or B is accepted. project B. The cash flow and project outlay of the joint projects also should have been combined.

. However.ranked solely based on their merits. in our case we are compelled to consider dependency condition first and then only other ranking parameters which will not lead us to the optimum result. So dependent projects should be treated as single projects as explained above.

cost-benefit analysis are also important in capital budgeting evaluation process. may not have an immediate. possibility of technology change. but it can boost employee morale and result in greater productivity. evaluation of qualitative and quantitative factors. quantitative measures only assist on managerial decision by providing the facts and figures for manager to prove their decisions to be rational. The opportunities and constraints of selecting a project. qualitative measures are equally important.Question 10 Do you think that the quantitative measures alone are important in capital budgeting evaluation? What qualitative factors could also be important in capital budgeting evaluation? The main objective of any firm is to increase the shareholders wealth and maximize the profits for the firm. the firm tries to evaluate additional wealth each projects would generate if undertaken. Basically. and the weightage on every bit of pros and cons. the reliability of figures like cash flows. trend of government policies etc considerably affect capital budgeting process. The vision of judgement of future also plays an important role as factors like market potential. The effect of capital budgeting on employee moral also has to be considered as employees are the person who will make the projects successful. Risk associated in all the projects also have to be studied properly and if these risks are considered then only the outcome capital budgeting process can be reliable. for example. Some of the important qualitative factors in capital budgeting evaluation are as follows: First of all. However. With the quantitative measures of capital budgeting evaluation. Ordering new office furniture.If these figures are authentic then only the quantitative measures can be trusted upon. . quantifiable payback for the corporation. for complete evaluation of capital budgeting. cost of capital etc which help to evaluate quantitative measures should be ascertained.

000 292.000 155.000 -228.000 323.000 136.000 -92.000) = 3.000 -677.000 270.000 -364.000 938.000 .000.000 Payback Period = 1 + (130.000 140.000 295.000 370.1486 years Project B Original Investment Year 1 Year 2 Year 3 Year 4 Cash Flows Cumulative Cash Flows -500.000.000 -130.000 1.261.584.000 136.800 Original Investment Year 1 Year 2 Year 3 Year 4 Cumulative Cash Flows -500.000 -1.000 323.000 323.000 615.000/618.000 -500.000 323.000/270.4814 years Project C Original Investment Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Cash Flows Cumulative Cash Flows -1.000 526.000 323.000 323.Annex Calculation of Payback Period Project A Cash Flows -500.000 323.000 1.000 49.000 136.000) = 1.000 -354.000 -31.000 323.000 618.000 344.800 Payback Period = 3 + (92.

800 0.8264 0.683 0.6 70720.000 2.000/323.6575 89420 -187662.000 200.6 -217949.4 136.000 25.000 1.6 .Year 9 Year 10 323.000 175.000 -500.000 136.907.000 175.000 0.000 136.000) = 3.5718 353829.53 years At 21 % discount rate Year 0 1 2 3 4 Cash Flows -500.000 0.4665 PV -500000 112390.84) = 3.000.6 -381734.000 1 -500000 -500000 136.000 Payback Period = 3+(1.0959 years Project D Original Investment Year 1 Year 2 Year 3 Year 4 Year 5 Cash Flows Cumulative Cash Flows -500.000 -150.2 Cumulative CFs -500000 -387609.000 Payback Period = 2+(500.000 175.000/175.000 0.000 375.5645 0.7695 104652 -277082.000)= 2.230.000 323.8696 118265.4 136.86 years Discounted Payback Period for Project A At 15 % discount rate Year 0 1 2 3 4 Cash Flows PVIF@15% PV Cumulative CFs -500.44 Discounted Payback Period = 3 + (187662.000 175.4/353829.800 PVIF@21% 1 0.000 136.4 618.000 618.84 166167.000 -325.6 -294721.000 175.4 92888 76772 288670.

7 848137.000 49.5 212372.9 121415.000 323.2 29429.5 184691.3269 0.2 159447.000 1 -500000 -500000 370.3 241801.000 323.5 22858.7695 0.000 370.000 323.000 0.8696 321752 -178248 270.2 587088.000 0.5645 0.5718 28018.7 105588.000 0.000 0.86 years At 21% discount rate Year 0 1 2 3 4 Cash Flows -500.8 426493.4323 0.5718 0.5 131429.4 953726.000 PVIF@21% 1 0.5) = 2.000 270.7 91828.000 323.8 726721.000 323.6575 0.000 323.683 0.3759 0.1 1045555 .6575 101912.2) = 3.11 years Project C @ 15 % discount rate Year 0 1 2 3 4 5 6 7 8 9 Cash Flows -1.6 139632.Discounted Payback Period = 3 + (217949.000 PVIF@15% 1 0.000.000 323.000 323.000 323.8 248548.5 100534 Discounted Payback Period = 2 + (9822/87497.8264 0.000 155.5 Cumulative CFs -500000 -194232 -9822 77675.2843 PV -1000000 280880.7 Discounted Payback Period = 1 + (178248/207765) = 1.76 years Project B At 15 % discount rate Year 0 1 2 3 4 Cash Flows PVIF@15% PV Cumulative CFs -500.7695 207765 29517 155.4665 PV -500000 305768 184410 87497.4 160595.4972 0.6/288670.9 Cumulative CFs -500000 -219119.5 49.8696 0.

5) = 2.000 0.000 0.5645 182333.2 323.1486 47997.7695 0.8 323.2/248548.8264 266927.8 547973.8 809409.8696 0.2633 85045.8 703304.7972 Cumulative CFs -500000 -347820 -213157.4 323.000 0.9 633019.3855 124516.4665 150679.07 years Project D At 15 % discount rate Year 0 1 2 3 4 5 Cash Flows -500.000 175.5 323.000 0.2 -233072.9 323.3186 102907.1799 58107.6 Discounted Payback Period = 1 + (219119.000 175.7 323.000 0.7 761411.000 0.2472 79845.7 323.5 445065.000 0.5 -98095 1970 141480 Discounted Payback Period = 3 + (98095/100065) = 3.000 175.5 115062.683 220609 -12463.88 years Project C @ 21 % discount rate Year 0 1 2 3 4 5 6 7 8 9 10 Cash Flows PVIF@21% PV Cumulative CFs -1.000 0.7 Discounted Payback Period = 2 + (12463.000 0.10 323.000.000 0.2176 70284.8 323.000 0.000 175.000 PVIF@15% PV -500000 152180 134662.000 1 -1000000 -500000 323.6 1125400.8/182333.5 320549.6575 0.000 175.98 years At 21% discount rate Year Cash Flows PVIF@21% PV Cumulative CFs .5 169869.5718 0.5 100065 139510 1 0.2 323.5) = 1.

4665 0.NPV of HR (HR–LR) = 26 + (7135.5569 PV -500000 276131 150363 PVIF @ 35% 1 0.4882 0.2 237866.7937 0.6 141480 21% discount rate 70720.4 67986.84/ 7135.4 84320 66395.000 370.84 PVIF @ 27% 1 0.5 67462.5 -500000 -355380 -235855 -137067.7 12032.7407 0.683 0.000 136.7874 0.7 625400.000 PVIF @ 34% 1 0.3968 PV -500000 107943.68 years Net Present Value From above calculation of Discounted Payback Period we can determine the Net Present Value: Project A B C D 15% discount rate 166167.000 175.5) = 4.000 1 0.7463 0.5645 0.3844 PV -500000 107086.3855 -500000 144620 119525 98787.84+4331.800 PVIF @ 26% 1 0.62 0.000 270.68) (1) = 26.5 Discounted Payback Period = 4 + (55430/67462.000 175.0 1 2 3 4 5 -500.6299 0.5 -55430 12032.6 100534 309409.4999 0.000 136.68 IRR = Lower Rate + NPV of LR / NPV of LR .44 159447.000 175.5487 PV -500000 274059 148149 .62% Project B Year 0 1 2 CFs -500.000 175.000 618.5 IRR (Internal Rate of Return) Project A Year 0 1 2 3 4 NPV CFs -500.84 7135.72 -4331.5 81637.2 85666.4 245539.8264 0.000 175.000 136.

8197 0.4 116635.000 323.1 IRR = Lower Rate + NPV of LR / NPV of LR .5374 0.4552 0.1594 0.000 323.9 -46.5 IRR = Lower Rate + NPV of LR / NPV of LR .6 191119.3501 0.4514 0.3552 PV -500000 142275 115675 94045 76457.000 175.000 323.000 323.5 .3611 0.6 51486.3102 64418 15199.6009 0.6 194090.4156 0.1682 0.7 70091 54328.7 150453.000 175.5507 0.000 323.0943 0.0784 PV -1000000 250389.5 117582.000 PVIF @ 29% 1 0.5917 0.1 147029.2 39599.6 113082.0725 PV -1000000 248451.8 0.9 66925.1) (1) = 34.6719 0.000 323.3 25323.000 175.4064 0.3011 62992 14753.5 PVIF @ 23% 1 0.5 -1445.217 0.000 323.8+46.000 PVIF @ 22% 1 0.NPV of HR (HR–LR) = 29 + (26494/26494+1445.3 86983.5) (1) = 29.3 4 NPV 155.9 23417.6 42119.7692 0.000.8 30458.2799 0.95% Project D Year 0 1 2 3 4 5 NPV CFs -500.1011 0.99% Project C Year 0 1 2 3 4 5 6 7 8 9 10 NPV CFs -1.8 6111.000 49.1226 0.661 0.4658 0.2 32655.3 90407.5 78995 64750 1147.5 62160 -9387.000 175.37 PV -500000 143447.2693 0.8/ 6111.000 175.000 323.NPV of HR (HR–LR) = 34 + (6111.1304 0.2 26494 PVIF @ 30% 1 0.813 0.4369 0.000 323.5 96372.000 323.7752 0.2072 0.000 0.

NPV of HR (HR–LR = 22 + (1147.5+9387.11% .5/ 1147.IRR = Lower Rate + NPV of LR / NPV of LR .5) (1) = 22.

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