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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

Solution Preview

Please refer attached file for better formatting of solutions.

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.

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