# Capital Budgeting Models : Choosing the Investment Project/s

1) Suppose a company is considering two investment projects. Both projects require an upfront expenditure of $30 million. The company estimates that the cost of capital is 10% and that the investments will result in the following after-tax cash flows (in millions of dollars). Complete parts (a) through (e) below.

Year Project A Project B

1 $28 $10

2 $20 $15

3 $10 $20

4 $5 $25

a) Find the regular payback period for each project.

b) Find the discounted payback period for each project.

c) Assume that the two projects are independent and the cost of capital is 10%. Which project or projects should the company undertake? Base your results on the NPV.

d) Assume that the two projects are mutually exclusive and the cost of capital is 5%. Which project or projects should the company undertake? Base your results on the MIRR.

e) Explain why quantitative measures may not always be the best way to evaluate a project.

2) Suppose a company is considering two independent projects, Project A and Project B. The cash outlay for Project A is $14,000. The cash outlay for Project B is $20,000. The company's cost of capital is 12%. The following table shows the after-tax cash flows. For each project, compute the NPV, the IRR, the MIRR, and indicate the accept/reject decision.

Year Project A Project B

1 $4800 $6700

2 $4800 $6700

3 $4800 $6700

4 $4800 $6700

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#### Solution Preview

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a) Find the regular payback period for each project.

Project A

Year Cash Flow Cumulative cash Flow

0 -$30 -$30

1 $28 -$2

2 $20 $18

3 $10 $28

4 $5 $33

We find that initial investment of $30 M is recovered in 2nd year.

Payback period=1+(amount to be recovered in Year 2)/Cash flow in year 2=1+(2/20)=1.1 years

Project B

Year Cash Flow Cumulative cash Flow

0 -$30 -$30

1 $10 -$20

2 $15 -$5

3 $20 $15

4 $25 $40

We find that initial investment of $30 M is recovered in 3rd year.

Payback period=2+(amount to be recovered in Year 3)/Cash flow in year 3=2+(5/20)= 2.25 years

b) Find the discounted payback period for each project.

Project A

Year,n Cash Flow, Cn PV=Cn/(1+10%)^n Cumulative PV of cash Flow

0 -$30 -30/(1+10%)^0=-30.00 -30.00

1 $28 28/(1+10%)^1=25.45 -4.55

2 $20 20/(1+10%)^2=16.53 11.98

3 $10 10/(1+10%)^3=7.51 19.50

4 $5 5/(1+10%)^4=3.42 22.91

We find that initial investment of $30 M is recovered in 2nd year.

Discounted Payback period=1+(PV to be recovered in Year 2)/PV of Cash flow in year 2=1+(4.55/16.53)= 1.28 years

Project B

Year,n Cash Flow, Cn PV=Cn/(1+10%)^n Cumulative PV of cash Flow

0 -$30 -30/(1+10%)^0=-30.00 -30.00

1 $10 10/(1+10%)^1=9.09 -20.91

2 $15 15/(1+10%)^2=12.40 -8.51

3 $20 20/(1+10%)^3=15.03 6.51

4 $25 25/(1+10%)^4=17.08 ...

#### Solution Summary

Capital budgeting techniques helps us in evaluating the given investment projects. Solutions to given problems depict the methodology to calculate NPV, payback period, discounted payback period, IRR and MIRR for the given projects.

Financial Mang.

Discussion 1

• Assume that you recently received your MBA and now work as an assistant to the CFO of a large corporation. Your boss has asked you to prepare a financial forecast for the coming year. Address the following questions:

• How would you set up the model to be presented to the executives? How many scenarios would you choose? What other information would you provide? What would you not include and why?

• What are the pros and cons of being able to examine the results of changing dividend policy and capital structure policy?

• What are the values of financial forecasting? What is your opinion of the most important points to keep in mind when creating financial forecasts?

Discussion 2

• Why is the NPV method for budgeting accepted as the most valuable budgeting tool? If you were not allowed to use NPV for a budget you were developing, what other method(s) would you use? Explain your choices.

• Project S has a cost of $10,000 and is expected to produce cash flows of $3,000 per year for 5 years. Project L costs $25,000 and is expected to generate cash flows of $7,400 per year for 5 years.

• What is the NPV, IRR, MIRR, and PI for each project, assuming a 12 percent cost of capital?

• Which project would you select, assuming they are mutually exclusive, using each ranking? Why? Which project should you actually choose? Why?

• How do simulation analysis and scenario analysis differ in the way they treat very bad and very good outcomes? What does this imply about using each technique to evaluate risk?

Discussion 3

Franco Modigliani and Merton Miller are considered the architects of capital structure theory. They had many ideas regarding capital structure and the implications of that structure on a firm's performance. Since their first article was published in 1958, many financial theorists have attempted to test the validity of existing capital theories. This assignment will allow you to take a look at some major capital structure theories and how they influence finance.

• What does the following statement mean to you? "One type of leverage affects both EBIT and EPS. The other type affects only EPS."

• What conclusions did Modigliani and Miller draw regarding the effect of capital structure on a firm's value and cost of capital, assuming no corporate taxes?

• How do their conclusions change when each introduces corporate taxes? Explain.

• If a firm's managers thought that Modigliani and Miller were exactly right, what capital structure would they choose to maximize their firm's value? Why?

• Choose two criticisms of the MM models of capital structure. Write an argument positing that those criticisms do not outweigh the benefits of those theories.

Discussion 4

• Have you ever wanted to go into business for yourself? Why or why not?

• What tradeoffs does the entrepreneur face?

• Why is entrepreneurship so important in a market economy?