BASICS OF CAPITAL BUDGETING

Handout # 4
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Basics of Capital Budgeting

Q1:

Finance team of Hilton Inc., is undertaking capital budgeting to analyze two proposed capital
investments, namely Project “A” and “B”. Both projects have a cost of $ 10,000 and useful life of 4 years.
Firm’s cost of capital is 12%. Cash flow streams of both projects are given below:

(USD in ‘000s)
Time Project “A” Project “B”
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

Required:
a) Calculate both projects payback period, NPV, IRR, MIRR and PI.
b) Assuming both projects are independent, which project should be selected?
c) Assuming projects are mutually exclusive, which project should be selected?
d) Present a helicopter view of two projects based on capital budgeting techniques applied on part
a above.
Q2:

You have been asked by the CEO of ENI Construction Inc., to evaluate the proposed acquisition of a new
earth mover. The mover’s basic price is $ 50,000 and it would cost another r$ 10,000 to modify it for
special use in the newly awarded contract site. The mover will require increase in net working capital
(spare parts) of $ 2,000. Assuming the mover falls in MACRS 3-year class i.e, 33%, 45% and 15%
depreciation slabs apply in year 1, 2 and 3 respectively. After 3 years, the mover would be sold at$
20,000. The earth mover will have no effect on revenues but is expected to save ENI $ 20,000 pa in
before-tax operating costs, mainly labour. The company’s marginal tax rate is 40%.

Required:
a) What is the net cost of the earth mover?
b) What are the operating cash flows in years 1, 2 and 3 respectively?
c) What are the additional non-operating cash flows in year 3?
d) If the project’s cost of capital is 10%, should the earth mover be purchased?

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