Prof.

Antonio Fernós FINA 5190 2019-13

Jose Solivan, M00277003

Capital Budgeting

1. Two projects being considered are mutually exclusive and have the following cash flows:

Year Project A Project B

0 −$50,000 −$50,000
1 15,625 0
2 15,625 0
3 15,625 0
4 15,625 0
5 15,625 99,500
If the required rate of return on these projects is 10 percent, which would be chosen and why?

The project to be selected will be Project B because it has a higher NPV.

NPV = ∑(CFn / (1 + i)n) - Initial Cash Flow

Project A Project B
Year Cash Flow Present Value Year Cash Flow Present Value
0 -$50,000 -$50,000 0 -$50,000 -$50,000
1 $15,625 $14,204.55 1 $0 $0
2 $15,625 $12,913.22 2 $0 $0
3 $15,625 $11,739.29 3 $0 $0
4 $15,625 $10,672.09 4 $0 $0
5 $15,625 $9,701.90 5 $99,500 $61,781.67
PV $9,231.04 NPV $11,781.67

2. Given the following information, compute the standard deviation for Investment A:

Investment A

Payoff Probability
20% 0.5
10% 0.4
−10% 0.1

= 13.0%

Investment A standard deviation is 9%.

Expected return (E[R]) = Σ (Payoff * Probability)

E[R] = (0.2 * 0.5) + (0.1 * 0.4) - (0.1 * 0.1) = 0.14 = 14%
Prof. Antonio Fernós FINA 5190 2019-13

Variance (Var[R]) = Σ [(Payoff - E[R]) ² * Probability]

Var[R] = (0.2 * (0.5 - 0.14) ²) + (0.1 * (0.4 - 0.14) ²) + (0.1 * (-0.1 - 0.14) ²) = 0.0081

Standard deviation = σ = √Var[R] = √0.0081 = 0.09 or 9%

3. Consider the following information, and then calculate the required rate of return for the
Scientific Investment Fund. The total investment in the fund is $2 million. The market required
rate of return is 15 percent, and the risk-free rate is 7 percent.

Stock Investment Beta

A $200,000 1.50
B 300,000 −0.50
C 500,000 1.25
D 1,000,000 0.75

For the Scientific Investment Fund, the required rate of return is 0.131 or 13.1%

CAPM = Ri = Rf + βi (Rm − Rf)

For Stock A: RA = 0.07 + 1.50(0.15 − 0.07) → RA = 0.19

For Stock B: RB = 0.07 + (−0.50) (0.15 − 0.07) → RB = 0.03

For Stock C: RC = 0.07 + 1.25(0.15 − 0.07) → RC = 0.17

For Stock D: RD = 0.07+0.75(0.15−0.07) → RD = 0.13

Fund weighted average required rate of return:

R(portfolio) = I(A) / I(Total) * RA + I(B) / I(Total) * RB + I(C) / I(Total) * R(C) + I(D) / I(Total) * RD

R(portfolio) = (200,000 / 2,000,000) * 0.19 + (300,000 / 2,000,000) * 0.03 + (500,000 /

2,000,000) * 0.17 + (1,000,000 / 2,000,000) * 0.13

R(Portfolio) = 0.131 or 13.1%

a. 14.3%

4. Calculate the Payback Period for an investment Project with the following data:

Initial Investment: $450

Cash flow for year #1: $325
Cash flow for year #2: $65
Cash flow for year #3: $100
Prof. Antonio Fernós FINA 5190 2019-13

The Payback Period for an investment Project is 2.6 years.

Calculate Cumulative Cash Flow for each year:

Y1 end: $325
Y2 end: $325 + $65 = $390
Y3 end: $390 + $100 = $490

Cumulative Cash Flow at Year 2 end is $390, which is less than the initial investment of $450.
Cumulative Cash Flow for Year 3 end is $490, which is higher than the initial investment of $450.

Calculate the Exact Payback Period

At the end of Year 2, the unrecovered investment is: $450 - $390 = $60

Payback Period = 2 years + (Remaining Investment to be recovered / Cash Flow of the next year)
Payback Period = 2 + ($60 / $100)
Payback Period = 2.6 years