Capital budgeting exercises and answers

Advcane Capital Budgeting Applications

INTERMEDIATE FINANCIAL MANAGEMENT SPRING 2015

ADVANCED CAPITAL BUDGETING APPLICATIONS

GROUP PROJECT

There are six capital budgeting exercises in this assignment. Please read the below information, some designed to clarify the exercises.

1. All the exercises require that NPV, IRR, and MIRR calculations be checked on EXCEL. If you elect not to utilize EXCEL and there are careless mistakes, you will lose credit.

2. Each problem counts an equal weight, each.

3. This assignment is a group exercise, answers are to be prepared by each group as a single solution, your answers and work are not to be shared with any other member of the class, outside of your group.

4. Your answers are to be typed and you need to summarize your answers in the first section of your paper. Details on the calculations and the work are to be included as an appendix. This summary of your answers is required.

5. In Exercise 3:

a. All the cash flows are negative and are thus reflective of this value.

b. Assume this is a required investment and thus the firm will accept the least negative investment.

c. Equivalent Annual Annuity (EAA) is a concept we have discussed in class and is reinforced in our textbook on p. 479

d. An alternative to EAA, that our textbook suggests using is the replacement chain (common life) approach. (pp. 478-479) This can be used in this problem as an alternative to calculating EAA to answer this problem. I would suggest doing both to confirm consistency in your answers.

6. In Exercise 4:

a. In part 3 of this problem, the authors indicate four percentage rates for the cost of capital, these are different possible rates and it is the authors intent to have you calculate the NPV for each of these values. Thus, you will end up having four different NPV values.

b. Likewise, when calculating the MIRR, in part 2 of the problem, you will end up with four values for the MIRR, since there are four different values given for the cost of capital. Each represents a reinvestment rate.

c, You should make certain when calculating MIRR that you take it to a minimum of two significant digits to the right of the decimal. (i.e.

12.34%)

7. Both Exercises 5 and 6 ask you to first determine the relevant cash flows.

8. In Exercise 6, to estimate the relevant cash flows, use the below, it is similar to what our authors have discussed on P. 252, note that FCF=Free Cash Flow. Note that the formula (7-9) is correct, but there is a more applicable version of this formula that I am listing below:

FCFt= EBITt (l — T) + Depreciationt — Change in net operating working capitalt

In addition, since this is evaluating the introduction of a new product, it is not a AFCF since there is no product it is replacing. Use the above formula to calculate the FCFt.

9. This project is due March 2, 2015.

Capital Budgeting Exercises

1

You 8-•te öven the following cash flowB for an investment.

End of Year Cash Flow

($38,000)

1 (10,000)

2 20,000

3 20,000

4 20,000

5 20,000

Required:

1. Compute the net present value (NPV) and profitability index (PI) using required rate of 14 percent.

2. Compute the internal rate of return (IRR), and

3. Should the project be accepted? Why?

Exercise 2

The following are cash flows for two mutually exclusive investments:

End of Year

($40,000)

($90,000)

1-5

16,423

33,466

Each has the same risk and required rate-of 10 percent.

Required:

1 . Compute the NPV and IRR for each investment. and

2. Assuming no capital rationing, which investment alternative would Be prepared to provide numerical support for your

3. If these were independent investments, what would you recom- mend? Why?

Exercise 5

The Maltpon Company is considering replacing a piece of equipment that was purchased five year8 ago for $100,000 and is. being on a sånight-line basis over a ten-year life to 8. zero salvage value. It could be sold now for $40,000. A more efficient model is available that costs $400,000, including installation costs. It would be depreciated on 8 straight-line basis over its five-year life to a zero salvage value. This machine would save labor of $150,000 per year for five years. The new model would not affect the level of net working capital (NWC) required to support operations. The firm's marginal tax rate is 40 percent, and the required rate for this investment is 14 percent. (You may ignore the investment tax credit.)

Required:

I. Compute the NPV and IRR for the replacement, and MIRR-

2. What would you recommend? Why?

Exercise 6

The Elonton Company is considering the introduction of a new product. It would have a five-year life, and sales and earnings before interest and taxes (EBIT) are expected to be as follows:

End of Year Net Sales EBIT

1

$2.0 million

$150,000

2

3.0 million

300,000

3

.0 million

700,000

4

7.0 million

700,000

5

2.0 million

250,000

The level of (net) working capital would change as follows because of the new product: increase by $100,000 at time zero, increase by another $200,000 at the end of year one, fricrease by another $500,000 at the end of year 2, no further change until the end of year 4 when there is decrease of $400,000, and the balance is freed up at the end of year 5.

Equipment costing $1.3 million would be required. It would be depreciated on a straightrline basis over a five-year life to a zero salvage value. Finally, the firm's marginal tax rate is 30 percent, and the required late for this investment is 15 percent. (You may ignore the investment tax credit.)

284 CAPtTAÚ BUDGETING EXERCISES
Exercise 3

Management of the Mahon Company is trying to decide replace a machine every three years or every four years. Replacemenevery four years involves more maintenance but a capital often relative to replacing the machine every three years. Below arè.

relevant cash flows net of taxes, including depreciation tax shields, foy each alternative, You maý assume that the cash flows will bé the samÊA'. for each subsequent cycle.

End of Year Three-year Alternative Four-year Alternatiize.í

($70;000) ($70,000)

1 (40,000) (50,000) 2 (40,000) (50,000) 3 (30,000) (35,000) 4 (30,000)
Required: Using a discount rate of 8 percent, rely on the equivaleått annual annuity method to determine which alternative should bež< selected.

Exercise 4

Assume the following cash flows for ar.L investment:

End of Year Cash Flow

($100,000) 1 230,900 2 (133 000)
Required:

1. Should one even bother to evaluate this investment because its cash outflows exceed its inflows?

2. Compute the internal rates of return for this investment. How would you interpret these rates? Compute and interpret WRR.

3. Compute the NPV and recommend whether the project should be accepted at each of the following rates: 5 percent, 15 percent, 18 percent, and 25 percent.