Case study on capital budgeting with solution

Answer Q1:

We can rank the projects by simply inspecting the cash flows (mention bellow), yet it’s not a good measure to rank them.

We can’t rank the projects by only simple inspection of the cash flows because of the time value of money and cost of capital of companies. We use capital budgeting tools to measure financial performance of projects.

The Ranking by simply inspecting the cash flows:

Rank

1st

2nd

3rd

4th

5th

6th

7th

8th

Projects

3

5

8

4

1

7

6

2

Cash Flows

$10,000

$4,200

$4,150

$3,561

$3,310

$2,560

$2,200

$2,165

Answer Q2:

In order to rank these projects, in a purely quantitative manner, we used the following for the 8 projects:

A. Net Present Value (NPV)

B. Internal Rate of Return (IRR)

C. Payback Period (PP)

D. Profitability Index (PI)

A. Net Present Value (NPV)

Year

Project 1

Project 2

Project 3

Project 4

Project 5

Project 6

Project 7

Project 8

0

($2,000)

($2,000)

($2,000)

($2,000)

($2,000)

($2,000)

($2,000)

($2,000)

1

300.00

1,514.55

-

145.45

254.55

2,000.00

1,090.91

(318.18 )

2

272.73

276.03

-

165.29

231.40

-

743.80

(49.59)

3

247.93

123.97

-

262.96

210.37

-

225.39

45.08

4

225.39

-

-

269.79

191.24

-

61.47

239.05

5

204.90

-

-

268.24

173.86

-

43.46

434.64

6

186.28

-

-

248.37

158.05

-

-

677.37

7

169.34

-

-

226.82

143.68

-

-

1,154.61

8

466.51

-

-

207.13

130.62

-

-

-

9

-

-

-

189.15

118.75

-

-

-

10

-

-

-

172.72

107.95

-

-

-

11

-

-

-

157.72

98.14

-

-

-

12

-

-

-

143.70

89.22

-

-

-

13

-

-

-

130.64

81.11

-

-

-

14

-

-

-

119.03

73.73

-

-

-

15

-

-

-

-

67.03

-

-

-

S PV(CF)

2,073.086

1,914.545

2,393.920

2,228.222

2,129.702

2,000

2,165.041

2,182.984

NPV

73.086

(85.455)

393.920

228.222

129.702

0

165.041

182.984

Rank

6th

8th

1st

2nd

5th

7th

4th

3rd

B. Internal Rate of Return (IRR)

Projects

Project 1

Project 2

Project 3

Project 4

Project 5

Project 6

Project 7

Project 8

IRR

10.87%

6.31%

11.33%

12.33%

11.12%

10.00%

15.26%

11.41%

Rank

6th

8th

4th

2nd

5th

7th

1st

3rd

All of these projects are accepted except Project 2 because its cost of capital has higher percentage than the percentage project internal rate of return. Moreover, Project 6 will be a subject of be in different because the cost of capital equal to internal rate of return, which lead to break even project.

COC = 10%

C. Payback Period (PP)

In Payback Period there are two method, non-discounted cash flow and discounted cash flow. Drawback of non-discounted cash flow does not consider TVM and the rate of return, and the discounted cash flow does not examine all the cash flows.

Projects

Project 1

Project 2

Project 3

Project 4

Project 5

Project 6

Project 7

Project 8

Payback Year

7

2

15

6

8

1

2

7

Payback

2,310

2,000

10,000

1,977

2,240

2,200

2,100

4,150

Discounted Payback

1,606.58

1,790.58

2,393.92

1,360.10

1,493.78

2,000

1,834.71

2,182.98

Decision (DPP)

Reject

Reject

Accept

Reject

Reject

Be in different

Reject

Accept

Rank

6th

5th

1st

8th

7th

3rd

4th

2nd