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Capital Budgeting Problems

P2. Benson Designs has prepared the following estimates for a long-term project it is considering. The initial investment is $18,250, and the project is expected to yield after-tax cash inflows of $4,000 per year for 7 years. The firm has a 10% cost of capital.

a. Determine the net present value (NPV) for the project.
b. Determine the internal rate of return (IRR) for the project.
c. Would you recommend that the firm accept or reject the project? Explain your answer.

P4. Caradine Corp., a media services firm with net earnings of $3,200,000 in the last year, is considering several projects:

Project Initial Investment Details
A $ 35,000 Replace existing office furnishings.
B 500,000 Purchase digital film-editing equipment for use with several existing accounts.
C 450,000 Develop proposal to bid for a $2,000,000 per year 10-year contract with the U.S. Navy, not now an account.
D 685,000 Purchase the exclusive rights to market a quality educational television program in syndication to local markets in the European Union, a part of the firm's existing business activities

The media services business is cyclical and highly competitive. The board of directors has asked you, as chief financial officer, to do the following:

a. Evaluate the risk of each proposed project and rank it low, medium, or high.
b. Comment on why you chose each ranking.

Solution Preview

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P2. Benson Designs has prepared the following estimates for a long-term project it is considering. The initial investment is $18,250, and the project is expected to yield after-tax cash inflows of $4,000 per year for 7 years. The firm has a 10% cost of capital.

a. Determine the net present value (NPV) for the project.

The cash inflows are an annuity- $4000 for 7 years

We use PVIFA factor to calculate the discounted value of future cash flows
PVIFA= Present Value Interest Factor for an Annuity
It can be read from tables or calculated using the following equations
PVIFA( n, r%)= =[1-1/(1+r%)^n]/r%
Present value of future cash flows = PVIFA x Annual Cash Flow

n= 7 years
r= 10.00%
PVIFA (7 years, 10.% rate ) = 4.8684

Initial investment= $18,250
Annual cash flow= $4,000

Present value of future cash flows= $19,474 =4.8684 x $4,000

Therefore NPV= $1,224 =$19,474 - $18,250

Present Value factor for an Annuity ...

Solution Summary

Answers 2 questions, one on capital budgeting techniques of NPV, IRR, the other on evaluating the risk of projects.

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