CHAPTER 9 - CAPITAL BUDGETING TECHNIQUE

1. You are a financial analyst for Damon Electronics Company. The director of capital
budgeting has asked you to analyze two proposed capital investments, Project X and Y.
Each project has a cost of $10,000, and the required return for each project is 12
percent. The projects’ expected cash flows are as follows:
Expected net cash flows
Year Project X Project Y
0 (10,000) (10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

a) Calculate each project’s traditional payback period, net present value (NPV), internal rate
of return (IRR), modified internal rate of return (MIRR), and Discounted Payback Period
(DPB).
b) Which project or projects should be accepted if they are independent?
c) Which project should be accepted if they are mutually exclusive?

Answer (a):

Payback Period (PB):

Project X Project Y
Year Cash Flow Cumulative CF Cash Flow Cumulative CF
0 ($ 10,000) ($ 10,000) ($ 10,000) ($ 10,000)
1 6,500 (3,500) 3,500 (6,500)
2 3,000 (500) 3,500 (3,000)
3 3,000 2,500 3,500 500
4 1,000 3,500 3,500 4,000

500×12
Paybackx = 2 + = 2 year 2 months
3000

3000×12
Paybacky = 2 + = 2 year 10.28 months
3500
Net Present Value (NPB):

NPVX = - Initial Investment + CF1/(1+i)n + CF2/(1+i)n + CF3/(1+i) n + CF4/(1+i) n

= - $ 10,000 + $ 6,500/(1.12) + $ 3,000/(1.12)2+ $ 3,000/(1.12)3+ $ 1,000/(1.12)4

= $ 966

NPVY = - Initial Investment + CF1/(1+i)n + CF2/(1+i)n + CF3/(1+i) n + CF4/(1+i) n

= - $ 10,000 + $ 3500/(1.12) + $ 3500/(1.12)2+ $ 3500/(1.12)3+ $ 3500/(1.12)4

= $ 631

Discounted Payback Period (PB):

Project X Project Y
Year Cash Flow 12%PVIF Cumulative CF Cash Flow 12%PVIF Cumulative CF
0 ($10,000) ($10,000) ($10,000) ($10,000) ($10,000) ($10,000)
1 $6,500 $5,804 ($4,196) $3,500 $3,125 ($6,875)
2 $3,000 $2,392 ($1,805) $3,500 $2,790 ($4,085)
3 $3,000 $2,135 $330 $3,500 $2,491 ($1,594)
4 $1,000 $636 $966 $3,500 $2,224 $630

$1,805×12
PBDiscX = 2 + = 2 year 10.15 months
$2,135

$1,594×12
PBDiscY = 3 + = 3 year 8.6 months
$2,224

Answer (b):
Note that all methods rank project X over project Y. In addition, both projects are acceptable
under the NPV and PBDiscX criteria. Thus Both project should be accepted if they are
independent.

Answer (c):
In this case, we would choose the project with the higher NPV at r = 12%, or project X.