61FIN2FIM - FINANCIAL MANAGEMENT

TUTORIAL 8 – CAPITAL BUDGETING

Short Answer Questions

Use the following information to answer question 1 - 10

Projects A and B have the same expected lives and initial cash outflows. However, one project's cash flows
are larger in the early years, while the other project has larger cash flows in the later years. The following
NPV profiles of two mutually exclusive project A and B are provided as below

1. At the discount rate of 10%, which project should be undertaken under NPV criterion?

2. At the discount rate of 13%, which project should be undertaken under NPV criterion?

3. At the discount rate of 10%, which project should be undertaken under IRR criterion?

4. At the discount rate of 13%, which project should be undertaken under IRR criterion?

5. From what discount rate, the NPV and IRR methods yield the same decision?

6. From what discount rate, the NPV and IRR methods provides conflict decisions?

7. As a financial manager, you expect that the discount rate of 10% should be used to evaluate the two
projects. Which project should you pick?
8. As a financial manager, you expect that the discount rate of 13% should be used to evaluate the two
projects. Which project should you pick?

9. Which project has larger cash flows in the later years?

10. At what discount rate, the NPV of the two projects are the same?

11. What are independent projects? Mutually exclusive projects?

12. What is reinvestment rate used in IRR calculation? NPV calculation?

13. Why NPV is superior to IRR?

14. What are some problems of using IRRs in capital budgeting?

15. What criteria are used to measure project’s liquidity and what criteria are used to measure project’s
profitability?

Part 2 - Problems

1. Project K costs $52,125, its expected cash inflows are $12,000 per year for 8 years, and its WACC is 12%.

A. Calculate the project’s NPV.

B. Calculate the project’s IRR.

C. Calculate the project’s payback.

D. Calculate the project’s discounted payback.

E. Should the project be undertaken?

2. Your division is considering two projects with the following cash flows (in millions):

A. What are the projects’ NPVs assuming the WACC is 5%? 10%? 15%?

B. What are the projects’ IRRs at each of these WACCs?

C. Draw NPV profiles for the two projects.

D. Calculate the cross-over rate.

E. Based on the examination of NPV profile and given that the WACC was 5% and A and B were mutually
exclusive, which project would you choose? What if the WACC was 10% or 15%?

3. A firm with a 14% WACC is evaluating two projects for this year’s capital budget. After-tax cash flows,
including depreciation, are as follows:

A. Calculate NPV, IRR, payback, and discounted payback for each project.

B. Assuming the projects are independent, which one(s) would you recommend?

C. If the projects are mutually exclusive, which would you recommend?

4. Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of the
units; otherwise, the highly profitable plant would have to shut down. Two units are available, HCC and LCC
(for high and low capital costs, respectively). HCC has a high capital cost but relatively low operating costs,
while LCC has a low capital cost but higher operating costs because it uses more electricity. The costs of the
units are shown here. Kim’s WACC is 7%.

A. Which unit would you recommend? Explain.

B. If Kim’s controller wanted to know the IRRs of the two projects, what would you tell him?