# 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.

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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.

Present Value and Capital Budgeting Problems

Part I: This part tests my your ability to calculate present value.

A. Suppose your bank account will be worth $15,000.00 in one year. The interest rate (discount rate) that the bank pays is 7%. What is the present value of your bank account today? What would the present value of the account be if the discount rate is only 4%?

B. Suppose you have two bank accounts, one called Account A and another Account B. Account A will be worth $6,500.00 in one year. Account B will be worth $12,600.00 in two years. Both accounts earn 6% interest. What is the present value of each of these accounts?

C. Suppose you just inherited a gold mine. This gold mine is believed to have three years worth of gold deposit. Here is how much income this gold mine is projected to bring you each year for the next three years:

Year 1: $49,000,000

Year 2: $61,000,000

Year 3: $85,000,000

Help me Compute the present value of this stream of income at a discount rate of 7%. Remember, you are calculating the present value of a whole stream of income, i.e. the total value of receiving all three payments (how much you would pay right now to receive these three payments in the future). Your answer should be one number - the present value of this gold mine at a 7% discount rate but you have to show how you got to this number.

Now compute the present value of the income stream from the gold mine at a discount rate of 5%, and at a discount rate of 3%. Compare the present values of the income stream under the three discount rates and write a short paragraph with conclusions from the computations.

Part II: Capital Budgeting Practice Problems

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

Year Cash flow

0 - $400,000

1 $100,000

2 $120,000

3 $850,000

- If the discount rate is 0%, what is the project's net present value?

- If the discount rate is 2%, what is the project's net present value?

- If the discount rate is 6%, what is the project's net present value?

- If the discount rate is 11%, what is the project's net present value?

- What is this project's modified 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?

B. Consider a project with the expected cash flows:

Year Cash flow

0 -$815,000

1 $141,000

2 $320,000

3 $440,000

- What is this project's internal rate of return?

- If the discount rate is 1%, 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 10%, what is this project's net present value?

- If the discount rate is 18%, 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?

C. A project requiring a $4.2 million investment has a profitability index of 0.94. What is its net present value? (Remember: Profitability Index is defined as Present Value of the proceeds divided by the initial investment)

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