Capital Budgeting Activity 2

Read the chapter 10 and answer the following questions: Marks 5

Q1: A firm with a WACC of 10 percent is considering the following mutually exclusive projects

Project A Cash flows Project B

Years
0 -$400M -$600M

1 $55 $300

2 $55 $300

3 $55 $50

4 $225 $50

5 $225 $49

Requried: Use above information to calculate

 Payback period
 Discounted payback period
 NPV
 Profitability Index
 IRR

b: If the projects are mutually exclusive, which project would you recommend?

c: Notice that the projects have the same cash flow timing pattern. Why is there a conflict
between NPV and IRR?
 SOLUATION
QUESTION

Payback period

Payback period of project A = 4 years + 10/225 = 4+0.04 = 4.04 years

Payback period of project B = 2 years + 0/50 = 2 years

Discounted payback period

Total of discounted period of project A = 50+45.53+41.31+153.68+138.73 = 430.15

Total discounted period of project B = 272.7+247.8+37.6+34.2+30.5 = 622.8

Explain.WACC = 10%

Project A:

NPV = CF0+ CF1 / (1+r)1+ CF2 / (1+r)2+ CF3/ (1+r)3 + CF4/ (1+r)4+ CF5/ (1+r)5NPV = -$400 +

55 / (1 + 10%)1+ 55 / (1 + 10%)2+ 55 / (1 + 10%)3+ 225 / (1 + 10%)4+ 225 / (1 + 10%)5= $30.162

Project B:

NPV = CF0+ CF1 / (1+r)1+ CF2 / (1+r)2+ CF3/ (1+r)3 + CF4/ (1+r)4+ CF5/ (1+r)5NPV = -$600 +

300 / (1+10%)1+ 300 / (1+10%)2+ 50 / (1+10%)3+ 50 / (1+10%)4+ 49 / (1+10%)5= $22.802

Profitability Index

Project A
= 1 +[ NPV/ICO]

= 1+[30.35/400]

PI = 1.075

Project B

= PI =1+[NPV/ICO]

1+[23.25/600]

PI =1.038

IRR of project A = 7%+(105.9 * (10%-7%))/ (105.9-30.15)

=7% + 3.177/75.75
=7% + 4.19 %
= 11.19%

IRR of project B = 7%+(55.9 * (10%-7%))/(55.9-22.8)

=7% + 1.677/33.1
=7% + 5.06%
=12.06%

b: If the projects are mutually exclusive, which project would you recommend?

I would recommend project A because NPVA> NPVB($30.162 > $22.802).

c: Notice that the projects have the same cash flow timing pattern. Why is there a conflict
between NPV and IRR?

The conflict between NPV and IRR most likely occurs due to the difference in the size of the
projects, as Project B is TWO times larger than Project A