Integrative Problem

a) Capital Budgeting is the process of analyzing additions of fixed assets. Capital Budgeting is
important because more than anything else fixed asset investment decisions shape a company’s
future. The Capital Budgeting process is identical to the decision process used by individual making
investment decisions. In both cases, cash flows have to be estimated along with assessing the
riskiness of cash flows. Then based on assessment appropriate discount rate has been determined.
This rate also known as cost of capital. Then, present value of those cash flows has been calculated.
If the present value of cash inflows in greater than present value of cash outflow which indicates
positive NPV or if IRR is greater than cost of capital, and then project should be accepted.

b) Projects are independent if the cash flows of one project are not affected by the acceptance of
others. On the other hand, two projects are mutually exclusive when acceptance of one project
reject others, which means only one project can be accepted. Another way we can say that a
mutually exclusive project means they do the same job. Projects with conventional cash flows have
or cost in the first year followed by series of inflows later. On the other hand, projects with
unconventional cash flows have multiple outflows after the inflow streams begun.

c)
1. The payback period is the expected number of years required to recover a project’s cost. We
calculate the payback by developing the cumulative cash flows as shown below for both
Project L and Project S.

Expected Net Cash Flows (In thousands of dollars)

Year Project L Project S
0 $ (100) $ (100)
1 10 70
2 60 50
3 80 20
For Project L,

Unrecovered initial investment

Payback Period =
Number of yearsbefore full
(
recovery of initial investment

30
) (
+ at the start of recovery year
Total Cash flow generated
¿ recovery year
)
=2+
80

= 2.375 years

For Project S,

Unrecovered initial investment

Payback Period =
Number of yearsbefore full
(
recovery of initial investment

30
)
+
( at the start of recovery year
Total Cash flow generated
¿ recovery year
)
=1+
50

= 1.60 years
2. Payback represents a type of Breakeven Analysis. It tells us when the project will break even
in a cash flows sense. According to the payback criterion for maximum 2 years, Project S
should be accepted but Project L should not. Whether the projects are independent or
mutually exclusive makes no difference in this case.
3. Discounted Payback is similar to traditional payback technique except this method considers
discounted cash flows rather than regular cash flows. We calculate the discounted payback
for both Project L and Project S below.

For Project L,

Project L
Year Cash Flows Discount Factor (at 10%) Discounted Cash Flows
0 $ (100) 1 (100)
1 10 0.9091 9.091
2 60 0.8264 49.587
3 80 0.7513 60.105
 Unrecovered initial investment
Discounted Payback Period =
Number of yearsbefore full
(
recovery of initial investment

41.322
) (
+ at the start of recovery year
Total Cash flow generated
¿ recovery year
)
=2+
60.105

= 2.687 years

For Project S,
Project S
Year Cash Flows Discount Factor (at 10%) Discounted Cash Flows
0 $ (100) 1 (100)
1 70 0.9091 63.636
2 50 0.8264 41.322
3 20 0.7513 15.026

Unrecovered initial investment

Discounted Payback Period =
Number of yearsbefore full
(
recovery of initial investment

36.364
) (
+ at the start of recovery year
Total Cash flow generated
¿ recovery year
)
=1+
41.322

= 1.88 years
4. Traditional payback technique has two major limitations. Those are, it ignores the time value
of money and it also ignores the cash flows that occur after payback period. Discounted
payback technique does consider time value of money but it still does not consider cash
flows after the payback period. Still many firms calculate discounted payback period when
making capital budgeting decisions. However, payback is generally used as a rough measure
of a project's liquidity and riskiness.
d) 5. Net present value is simply the sum of the present values of project's cash flows. We calculate
the net present value for both Project L and Project S below.

For Project L,
Project L
Year Cash Flows Discount Factor (at 10%) Discounted Cash Flows
 0 $ (100) 1 (100)
1 10 0.9091 9.091
2 60 0.8264 49.587
3 80 0.7513 60.105

CF1 CF 2 CF 3
NPVL = CF0 + + +
(1+i) (1+i)2 (1+i) 3

10 60 80
= (100) + + +
(1.10) (1.10)2 (1.10)3

= (100) + 9.091 + 49.587 + 60.105

= 18.783 > 0

For Project S,
Project S
Year Cash Flows Discount Factor (at 10%) Discounted Cash Flows
0 $ (100) 1 (100)
1 70 0.9091 63.636
2 50 0.8264 41.322
3 20 0.7513 15.026

CF1 CF 2 CF 3
NPVS = CF0 + + +
(1+i) (1+i)2 (1+i) 3

70 50 20
= (100) + + +
(1.10) (1.10)2 (1.10)3

= (100) + 63.636 + 41.322 + 15.026

= 19.985 > 0
6. The rationale behind the Net present value method is very straightforward. If a project has zero
NPV, then the project generates enough cash flows to recover the cost of return and the project is
in break even. If the NPV is positive, then more than enough cash flow is generated and vice versa.
As both projects give us positive NPV balance, we can accept both projects. For Project L , NPV is $
18.783 and for Project S, NPV is $ 19.985. If both projects are independent, then both should be
accepted, because both projects add to shareholder's wealth. if the projects are mutually exclusive,
 then Project S should be selected over Project L. because Project S adds more to the value of the
firm.

7. The NPV of a project is depending on the require rate of return. Thus, if the require rate of return
changes, the NPV of each projects changes. NPV declines as require rate of return increase and NPV
rises as require rate of return falls.

e)

8. The internal rate of return is that specific discount rate which forces the NPV of a project to equal
zero. We calculate the internal rate of return for both Project L and Project S below.

For Project L,
For IRR calculation, we have to use interpolation formula (Trial and error method).

So, if i = 18 %,

10 60 80
NPVL = (100) + + +
(1.18) (1.18)2 (1.18)3

= (100) + 8.475 + 43.091 + 48.690

= 0.256

If i = 19 %,

10 60 80
NPVL = (100) + + +
(1.19) (1.19)2 (1.19)3

= (100) + 8.403 + 42.370 + 47.473

= (1.753)

NPV 1
So, IRRL = i1 + × (i2 - i1)
NPV 1+ NPV 2( Absolute Value)

0.256
= 0.18 + 0.256+1.753 × (0.19 – 0.18)

0.256
= 0.18 + 2.009 × 0.01

= 0.1813 or 18.13% > 10%

For Project S,
For IRR calculation, we have to use interpolation formula (Trial and error method).

So, if i = 23 %,

70 50 20
NPVS = (100) + + +
(1.23) (1.23)2 (1.23)3

= (100) + 56.911 + 33.049 + 10.748

= 0.707

If i = 24 %,

70 50 20
NPVS = (100) + + +
(1.24) (1.24)2 (1.24) 3

= (100) + 56.452 + 32.518 + 10.490

= (0.540)

NPV 1
So, IRRS = i1 + × (i2 - i1)
NPV 1+ NPV 2( Absolute Value)

0.707
= 0.23 + 0.707+0.540 × (0.24 – 0.23)

0.707
= 0.23 + 1.247 × 0.01

= 0.2357 or 23.57% > 10%

10. The internal rate of return measures a project’s profitability in the rate of return sense. If a
project’s IRR equals its cost of capital, then its cash flows are just sufficient to provide investors
with their require rate of return. An IRR greater than require rate of return implies an economic
profit, which accrues to the firm’s shareholders. On the other hand, an IRR lesser than require rate
of return implies an economic loss or a project that will not earn enough to cover its cost of capital.
Since Project L and Project S both have a require rate of return of 10% and both project have IRR
greater than 10% (Project L = 18.13% and Project S = 23.57%), both project should be accepted if
 they are independent. However, if they are mutually exclusive, Project S should be selected as it
has higher IRR.

11. IRRs are independent in terms of require rate of return. Therefore, neither IRR L nor IRRS would
change if require rate of return changes. However, the acceptability of the projects could be
changed. Project L would be rejected if require rate of return is greater than 18.13% and Project S
would be rejected if require rate of return is greater than 23.57%.

f)

12. The NPV profile for Project L and Project S are plotted in the figure below.

Discount Rate NPVL NPVS

0% $ 50 $ 40
5% 33.053 29.295
10% 18.783 19.985
15% 6.666 11.827
20% (3.704) 4.630
25% (12.640) (1.760)
 From the figure, it appears that the crossover rate is almost 9%.

13. The NPV profile shows that the IRR and NPV lead to the same accept/reject decision for any
independent project. Consider Project L, it intersects the X axis at its IRR 18.13%. According to IRR
rules project should be accepted if require rate of return is less than 18.13%. At the same time, if
require rate of return is less than 18.13%, then Project L’s NPV profile will be above the X axis and
NPV will be greater than zero. Thus for any independent project, NPV and IRR leads to the same
accept/reject decision. Now assume that Project L and Project S are mutually exclusive. In that
case, a conflict might arise. First, IRR S is 23.57% and IRR L is 18.13%. Therefore, regardless the size of
require rate of return, Project S should be ranked higher based on IRR criterion. However, the NPV
profile shows that NPVL > NPVS if require rate of return is less than the crossover rate. Therefore,
for any require rate of return less than the crossover rate, the NPV rule says to choose Project L but
IRR rules says to choose Project S. Thus, if require rate of return is less than the crossover rate, a
ranking conflict occurs.

g)

14. When NPV profile is plotted for any projects, there will be one project that must have a higher
vertical axis and steeper slope than others. A project’s vertical axis typically depends on the size of
the project and the size, timing of cash flows. Large projects and one with large distance cash flows
would generally be expected to have relatively higher vertical axis. The slope of the NPV profile
depends entirely on the timing pattern of cash flows. Long term projects have steeper NPV profile
than short term project. Thus we can say NPV profile can cross in two situations. First, when
mutually exclusive project differ in terms of size. And second, when the project’s cash flows differs
in terms of timing pattern and cash flow’s size.

15. The underlying cause of ranking conflicts is the reinvestment rate assumption. All discounted cash
flow methods assume that cash flows can be reinvested at same rate, regardless what is actually
done with the cash flows. NPV and IRR are both found by discounting. So, the both assume the
same discount rate. NPV assumes that cash flows can be reinvested at project's cost of capital,
while the IRR assumes reinvestment at IRR rate.
16. When NPV and IRR give conflicting ranking, NPV should be used as it is superior to IRR. NPV
method is better because it selects the project that adds more to shareholder's wealth.

h)
17. MIRR is the discount rate at which the present value of the project's cost is equal to the present
value of its terminal value, where the terminal value is found as the sum of the future values of
cash inflows compounded at the firm's required rate of return. We calculate the MIRR for both
Project L and Project S below.

For Project L,
Year Cash Flows
0 $ (100)
1 10
2 60
3 80

Present Value = 100

Terminal Value = {CF1(1+i)2+CF2(1+i)1+CF3(1+i)0}

= {10(1+0.10)2+60(1+0.10)1+80(1+0.10)0}

= 158.10

Number of Period =3

So, FV = PV(1+i)n

158.10 = 100(1+i)3

158.10
(1+i)3 =
100

(1+i)3 = 1.581

(1+i) = 1.165

i = 1.165 – 1

i = 0.165 or 16.50%
 So, MIRRL = 16.50%

For Project S,
Year Cash Flows
0 $ (100)
1 70
2 50
3 20

Present Value = 100

Terminal Value = {CF1(1+i)2+CF2(1+i)1+CF3(1+i)0}

= {70(1+0.10)2+50(1+0.10)1+20(1+0.10)0}

= 159.70

Number of Period =3

So, FV = PV(1+i)n

159.70 = 100(1+i)3

159.70
(1+i)3 =
100

(1+i)3 = 1.597

(1+i) = 1.1689

i = 1.1689 – 1

i = 0.1689 or 16.89%

So, MIRRS = 16.89%

18. MIRR is superior to the regular IRR as an indicator of a project's true rate of return or expected long
term rate of return. If a rate of return measure is needed MIRR should be used. Since Project L and
 Project S both have a require rate of return of 10% and both project have MIRR greater than 10%
(Project L = 16.50% and Project S = 16.89%), both project should be accepted if they are
independent. However, if they are mutually exclusive, Project S should be selected as it has higher
MIRR.
19. The MIRR has positive relationship with require rate of return. Thus, if the require rate of return
changes, the MIRR of each projects changes. MIRR increase as require rate of return increase and
MIRR falls as require rate of return falls.