Capital Budgeting Example - Payback

You are analyzing the following two mutually exclusive projects, where Project A is a 4-
year project and Project B is a 3-year project:

Project A Project B
Year Cash Flows Cash Flows
0 -$1,000 -$ 800
1 +350 +350
2 +400 +400
3 +400 +400
4 +400 -----

Assuming that cash flows are received evenly throughout the year, what are the
payback periods for Projects A and B?

PBA = 2 + (250/400) = 2.625 years

PBB = 2 + (50/400) = 2.125 years

Capital Budgeting Examples - Solutions Page 1

Capital Budgeting Example - NPV, IRR and PI

You are analyzing the following two mutually exclusive projects, where Project A is a 4-
year project and Project B is a 3-year project:

Project A Project B
Year Cash Flows Cash Flows
0 -$1,000 -$ 800
1 +350 +350
2 +400 +400
3 +400 +400
4 +400 -----

Assuming a discount rate of 15%, calculate the net present values, internal rates of
return, and profitability ratios for projects A and B.

Project A

CFj = -$1,000
CFj = $ 350
CFj = $ 400
CFj = $ 400
CFj = $ 400

I/YR = 15

Solve for NPV = $98.51

Solve for IRR = 19.68%

Solve for PI = $1,098.51 / $1,000 = 1.09851

Solve for PI = $98.51 / $1,000 = .09851

Project B

CFj = -$ 800
CFj = $ 350
CFj = $ 400
CFj = $ 400

I/YR = 15

Solve for NPV = $69.81

Solve for IRR = 20.07%

Solve for PI = $869.81 / $800.00 = 1.0873

Solve for PI = $69.81 / $800.00 = 0.0873

Capital Budgeting Examples - Solutions Page 2

Capital Budgeting Example - EAA

You are analyzing the following two mutually exclusive projects, where Project A is a 4-
year project and Project B is a 3-year project:

Project A Project B
Year Cash Flows Cash Flows
0 -$1,000 -$ 800
1 +350 +350
2 +400 +400
3 +400 +400
4 +400 -----

Assume that the cost of capital is 15% and that you use the Equivalent Annual Annuity
(EAA) method to evaluate these projects under infinite replication. Which project will
dominate in terms of NPV and by how much?

Project A

CFj = -$1,000
CFj = $ 350
CFj = $ 400
CFj = $ 400
CFj = $ 400

I/YR = 15

Solve for NPV = $98.51

_____

N = 4
I/YR = 15
PV = -98.51
FV = 0

Solve for PMT = $34.51 = EAA

Solve for NPV of EAA = $34.51 / 0.15 = $230.04

Project B

CFj = -$ 800
CFj = $ 350
CFj = $ 400
CFj = $ 400

Capital Budgeting Examples - Solutions Page 3

I/YR = 15

Solve for NPV = $69.81

_____

N = 3
I/YR = 15
PV = -69.81
FV = 0

Solve for PMT = $30.58 = EAA

Solve for NPV of EAA = $30.58 / 0.15 = $203.84

Project A dominates by $230.04 - $203.84 = $26.20

Capital Budgeting Examples - Solutions Page 4

Capital Budgeting Example - MIRR

You are analyzing the following project. Assuming that the cost of capital is 10%,
determine the IRR and MIRR for Project A

Project A
Year Cash Flows
0 -$1,000
1 +350
2 +400
3 +400
4 +400

Solve for IRR:

CFj = -$1,000
CFj = $ 350
CFj = $ 400
CFj = $ 400
CFj = $ 400

Solve for IRR = 19.68%

Alternatively,

CFj = -$1,000
CFj = $ 350
CFj = $ 400
Nj = 3

Solve for IRR = 19.68%

Solve for MIRR:

TV = ($400)(1.10)0 + ($400)(1.10)1 + ($400)(1.10)2 + ($350)(1.10)3

TV = $400.00 + $440.00 + $484.00 + $465.85 = $1,789.85

N = 4; PV = -1,000; FV = 1,789.85; Solve for MIRR = 15.67%

Capital Budgeting Examples - Solutions Page 5

Capital Budgeting Example - MIRR

Two projects being considered by a firm have the following projected cash flows:

Project A Project B
Year Cash Flows Cash Flows
0 ($150,000) ($150,000)
1 $ 75,000 0
2 $ 75,000 0
3 $ 75,000 $251,867

Based on this information you should be able to determine at what cost of capital
Projects A and B will have the same MIRR. (Hint: after you convert the cash flows for
Project A, what will they have to be equivalent to so that they will have the same MIRR
as Project B?) What is the NPV for Project A at this cost of capital and what is its
MIRR?

Given that the projects are of the same scale, the terminal values of their cash flows
must be equal for them to have the same MIRR. Therefore, we must find the COC that
will give Project A’s cash inflows a terminal value equal to $251,867:

N = 3
PV = $0
PMT = -$75,000
FV = $251,867

Solve for I/YR = 11.50%

Now solve for MIRRA

N=3
PV = -$150,000
PMT = 0
FV = $251,867

Solve for I/YR = MIRRA = 18.86%

Note: MIRRA = MIRRB

Alternatively,

CFj -$150,000
CFj $ 75,000
Nj 3

I/YR 11.5

Now solve for NPVA = $31,696.45

Capital Budgeting Examples - Solutions Page 6

Alternatively,

CFj -$150,000
CFj $ 0
CFj $ 0
CFj $251,867

Now solve for IRRA = MIRRA = 18.86%

Capital Budgeting Examples - Solutions Page 7

Capital Budgeting Example - Decision Trees

You are analyzing a project that has the following distribution of potential cash flows
(initial and conditional probabilities are in parentheses):

Year 0 Year 1 Year 2

$ 300 (.2)
$ 500 (.4) $ 500 (.6)
$ 700 (.2)

-$ 800

$1,000 (.3)
$1,200 (.6) $1,200 (.4)
$1,400 (.3)

If the appropriate risk-adjusted discount rate to use for this project is 15 percent, then
what are the net present value (NPV) and internal rate of return (IRR) for this project?

Calculate expected cash flows:

Year 0 = -$800

Year 1 = ($500)(.4) + ($1,200)(.6) = $920

Year 2 = [($300)(.2) + ($500)(.6) + ($700)(.2)][.4]

+ [($1,000)(.3) + ($1,200)(.4) + ($1,400)(.3)][.6]

= [$500][.4] + [$1,200][.6] = $920

CFj = -$800
CFj = $920
CFj = $920

I/YR = 15

Solve for NPV = $695.65

Solve for IRR = 79.18%

Capital Budgeting Examples - Solutions Page 8

Capital Budgeting Example - Cash Flow Estimation

Your company is thinking about taking on a new project. In analyzing the project, the
financial staff has brought together the following information:

• The new project will require an initial capital outlay of $10 million at Year 0. This
outlay will be used to purchase new equipment.
• This equipment will be depreciated using a MACRS 3-year class life.
• The equipment will have a salvage value of $400,000 at the end of four years.
• Inventories will rise by $1,000,000 at Year 0, and accounts payable will rise by
$500,000 at Year 0. This increase in net operating working capital will be
recovered at the end of the project’s life, Year 4.
• The new business is expected to have an economic life of four years. The
business is expected to generate sales of $10 million at Year 1, $12 million at
Year 2, $8 million at Year 3, and $6 million at Year 4. Each year, operating costs
(excluding depreciation) are expected to be 60 percent of sales.
• The company’s tax rate is 40 percent.
• The company is very profitable, so any accounting losses on this project can be
used to reduce the company’s overall tax burden.
• The project’s weighted average cost of capital (WACC) is 10 percent.

What is the expected net present value (NPV) of this project?

(Note: the following tables are to help you organize your calculations; a few values have
been included. However, you are not required to use these tables and there are other
ways of calculating the cash flows.)

Capital Budgeting Examples - Solutions Page 9

Item Year 0 Year 1 Year 2 Year 3 Year 4
Cost $10,000,000
Depreciation Rate 33.0% 45.0% 15.0% 7.0%
Depreciation

Item Year 0 Year 1 Year 2 Year 3 Year 4

Operating Cash Flows:
Sales $10,000,000 $12,000,000 $8,000,000 $6,000,000
Less: Operating Costs
Less: Depreciation
EBIT
Less: Taxes (40%) -$280,000 -$120,000 -$680,000 -$680,000
Net Income
Plus: Depreciation
Operating Cash Flows

Year 0 Year 1 Year 2 Year 3 Year 4

Other Cash Flows:
Initial Capital Outlay -$10,000,000
Salvage Value $400,000
Tax Effect of Salvage
Net Working Capital
Inventories
Accounts Payable
Recovery of NWC $500,000
Total Other Cash Flows $0 $0 $0

Total Net Cash Flow

Present Value at 10%

Net Present Value

Capital Budgeting Examples - Solutions Page 10

Item Year 0 Year 1 Year 2 Year 3 Year 4
Cost $10,000,000
Depreciation Rate 33.0% 45.0% 15.0% 7.0%
Depreciation $3,300,000 $4,500,000 $1,500,000 $700,000

Item Year 0 Year 1 Year 2 Year 3 Year 4

Operating Cash Flows:
Sales $10,000,000 $12,000,000 $8,000,000 $6,000,000
Less: Operating Costs -$6,000,000 -$7,200,000 -$4,800,000 -$3,600,000
Less: Depreciation -$3,300,000 -$4,500,000 -$1,500,000 -$700,000
EBIT $700,000 $300,000 $1,700,000 $1,700,000
Less: Taxes (40%) -$280,000 -$120,000 -$680,000 -$680,000
Net Income $420,000 $180,000 $1,020,000 $1,020,000
Plus: Depreciation $3,300,000 $4,500,000 $1,500,000 $700,000
Operating Cash Flows $3,720,000 $4,680,000 $2,520,000 $1,720,000

Year 0 Year 1 Year 2 Year 3 Year 4

Other Cash Flows:
Initial Capital Outlay -$10,000,000
Salvage Value $400,000
Tax Effect of Salvage -$160,000
Net Working Capital
Inventories -$1,000,000
Accounts Payable $500,000
Recovery of NWC $500,000
Total Other Cash Flows -$10,500,000 $0 $0 $0 $740,000

Total Net Cash Flow -$10,500,000 $3,720,000 $4,680,000 $2,520,000 $2,460,000

Present Value at 10% -$10,500,000 $3,381,818 $3,867,769 $1,893,313 $1,680,213

Net Present Value $323,113

Capital Budgeting Examples - Solutions Page 11