Capital budgeting practice problems. 1. Evaluation of Cash Flows.

Below are the cash flows for two mutually exclusive projects. year 0 1 2 3 4 CFX (5,000) 2,085 2,085 2,085 2,085 CFY (5,000) 0 0 0 9,677

a. Calculate the payback for both projects. b. Initially, the cost of capital is uncertain, so construct NPV profiles for the two projects (on the same graph) to assist in the analysis. The profiles cross at what cost of capital? What is the significance of that? c. It is now determined that the cost of capital for both projects is 14%. Which project should be selected? Why? d. Calculate the MIRR for both projects, using the 14% cost of capital. Answers: a. 2.4 yrs, 4 yrs; b. 10%; c. X; d. MIRRX = 19.69% 2. More practice with Cash Flow Evaluation. Cash flows for two mutually exclusive projects are shown below: year 0 1 2 3 CFM (100) 10 60 80 CFN (100) 70 50 20

Both projects have a cost of capital of 10%. a. Calculate the payback for both projects. b. Calculate the NPV for both projects. c. Calculate the IRR for both projects. d. Calculate the MIRR for both projects. Answers: a. 2.4 yrs, 1.6 yrs; b. $18.78, $19.98; c. 18.1%, 23.56%; d. 16.5%, 16.9%;

EAAX = $4. Use of the machine will require an increase in working capital of $70 for the 3 years. A machine has a cost of $180. Murray’s Coffee House is trying to choose between two new coffee bean roasters.000 CFY (30. Adjust the cash flows to reflect the effects of inflation. a.000 20. It will have a life of 3 years. b. It will result in sales revenue of $200 per year and cash operating costs of $110 per year. c. EAAY = $2. b. Calculate the replacement chain NPV for each project. Calculate the equivalent annual annuity for each project.58 4.000 terminal cash flow = 0 cost of capital = 14% T = 30% a.714 . RCNPVY = $8. c. $6. What is the NPV for the machine? Answers: a.000 20. Which NPV is the correct one for evaluating the project? a. b.226. b.000) 20.000 annual depreciation = $2.000 a.000 20. c. (Are these cash flows real or nominal?) Calculate the associated NPV.000 annual cash operating costs = $2.3. Calculate the initial cash flow at time 0.604. d. $202 5.000 20. 70. 78. beginning at year 0. has a 4-year life and provides expected cash flows as follows. -$133.397. which is expected to affect sales revenue and cash operating expenses at the rate of 4% annually. d. Mutually Exclusive Projects with Unequal Lives. Expansion Project. Shown below are the after-tax cash flows associated with each machine: year 0 1 2 3 4 CFX (50.000) 20. RCNPVX = $13. based on year 1 prices and costs: annual revenue = $5. Which project should be selected? Why? Answers: a. Inflation adjustment: A project requires an initial investment of $8. The appropriate discount rate is 8% and the firm’s tax rate is 40%. b.000. b. c. Calculate the annual operating cash flows without adjusting for inflation. (Are these cash flows real or nominal?) Calculate the associated NPV. The required rate of return for either machine is 10%. -250. Calculate the relevant terminal cash flows at the end of year 3. and will be depreciated straight line to zero salvage value. Calculate the annual operating cash flows (they are identical each year).

4 percent and the beta on Delta’s stock is 1. 10% . 5.03%. Which project(s) should be accepted in each of the following situations: (1) The projects are mutually exclusive and there is no capital constraint.000 25. has a stock price of $50. e. e. d. c. 8. Risk Adjustment and Project Selection.000 The opportunity cost of capital for A is 14 percent.000 20. Delta.274. Acme Mfg is considering two projects.3%. g. Answers: a. f.000 60. 13.39%.000 20. In the fiscal year just ended.00. c. Calculate the required return on the firm’s stock using CAPM. 12%. a. NPVB = $11. Cost of Capital. (2) The projects are independent and there is no capital constraint.000 25. New common stock can be sold to net $40 per share after flotation costs. a. d. 9.000 20. b. f. dividends were $2.25. Calculate the required return on the firm’s stock using the discounted cash flow approach. Calculate the WACC if equity financing is from the sale of common stock. Calculate the IRR for each project. Delta’s target capital structure is 40% debt and 60% common equity.000 and an 8% coupon rate paid annually for $960. Calculate the after-tax cost of debt financing.6. Calculate the NPV for each project. Answers: a. Calculate the cost of financing from the sale of common stock.000 of financing for capital outlays in the coming period. with cash flows as shown below: period 0 1 2 3 4 CFA -50.065. A & B. IRRA = 21.000 CFB -100.000 20. Earnings per share and dividends are expected to increase at an annual rate of 8 percent. b. Delta can sell bonds that mature in 25 years with a par value of $1.4%. g.000 25.86%. IRRB = 16. The risk-free rate is 4 percent. The opportunity cost of capital for B is 10 percent. c. the market risk premium is 6. b. Delta’s tax rate is 40 percent. Calculate the WACC if equity financing is from retained earnings. Inc.3%. (3) The projects are independent and there is a total of $100. Explain why the cost of capital for A might be higher than for B. Calculate the before-tax interest rate on new debt financing. 12. NPVA = $8. d.08% 7. b.

Calculate the expected NPV.500 3.675 -90 $3. 1. The tax rate is 40% and the required rate of return is 13%.000 NPV @ that Ann CF -$1.000 4. and depreciated straight line. Answers: a. Capital Budgeting Scenario Analysis Acme Mfg. 1. Calculate the incremental terminal cash flow. Its expected salvage value in 6 years is $2.3 . Calculate the incremental annual operating cash flows that result from the new machine.040.349 9. Scenario Worst Case Most Likely Best Case prob .000.900. A replacement machine can be purchased now for $7.000 or used for 6 more years at which time it will be sold for an estimated $500. $1. is considering a project that requires initial investment of $9. Acme classifies projects into high.079 a. The probability distribution of annual operating cash flows (over its 4-year life) is shown below. Show the incremental CFs in the table below. Calculate the incremental cash flow at time 0. b. It is being depreciated straight line over its 8 year life.000 annually.3 Ann CF $2. b. It would be used for 6 years.8. –$6.800. c. There are no other cash flows associated with the project. It provides revenue of $5. Calculate the NPV for this project. but because of its increased efficiency it would reduce cash operating costs by $600 per year. c. Year 0 1 2 3 4 Cash Flow ________ ________ ________ ________ ________ e.620. Should the old machine be replaced? a.600 and has a 4year life. It will result in additional sales revenue of $1. The new machine would require additional inventories of $700.4 . Replacement project: Existing machine was purchased 2 years ago at a cost of $3. average.500 annually.000 annually and cash operating costs of $2. c. Calculate the coefficient of variation (CV) of NPV. or low risk according to the CV of NPV as shown below: .200. d. Acme’s corporate weighted average cost of capital (WACC) is 10%. and accounts receivable would increase by $300. b. e. It can be sold now for $3. Calculate the standard deviation of NPV.

65.CV Below 2 Between 2 and 3 Above 3 risk low average high To determine the risk-adjusted discount rate (RADR) for each project.35 . $1.881. 4. e. Answers: a. -$32. Acme adds or subtracts 2% to the corporate WACC based on the CV. What is the RADR for this project? e. f. Should the project be accepted or rejected? State what your decision is based on.89. Calculate the expected NPV using the RADR. b. d.08. $385. c.

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