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Capital Budgeting: Net present value, IRR, discount profile

Part 1. Capital Budgeting Practice Problems

a. Consider the project with the following expected cash flows:

Year Cash flow
0 - $500,000
1 $100,000
2 $110,000
3 $550,000

If the discount rate is 0%, what is the project's net present value?
If the discount rate is 4%, what is the project's net present value?
If the discount rate is 8%, what is the project's net present value?
If the discount rate is 10%, what is the project's net present value?
What is this project's internal rate of return?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

[You can't upload the graph unto Coursenet. Look at the graph you draw and write a short paragraph stating what the graph 'shows"].

b. Consider a project with the expected cash flows:

Year Cash flow
0 - $615,000
1 141,000
2 300,000
3 $300,000

What is this project's internal rate of return?
If the discount rate is 0%, what is this project's net present value?
If the discount rate is 4%, what is this project's net present value?
If the discount rate is 8%, what is this project's net present value?
If the discount rate is 12%, what is this project's net present value?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate.

What is this discount rate at which the graph intersects the horizontal axis?
What does the graph 'show?

c. A project requiring a $3.2 million investment has a profitability index of 0.97. What is its net present value? (Remember: Profitability Index is defined as Present Value of the proceeds divided by the initial investment)

Part 2.

Which method do you think is the better one for making capital budgeting decisions - IRR or NPV?

Solution Summary

The problem deals with capital budgeting under finance. It deals specifically with determining the net present value (NPV), internal rate of return (IRR) and discount profile for selected projects.

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