Purchase Solution

# Finance: Capital budgeting.

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Part 1. 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?

[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 -\$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?

Observe the graph and write a short paragraph stating what the graph 'shows

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)

Part 2.
http://proquest.umi.com/pqdweb?index=0&did=290623921&SrchMode=1&sid=4&Fmt=4&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1195597756&clientId=29440&cfc=1

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

Abstract:
Internal rate of return (IRR) is the flip side of net present value (NPV) and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often a company's cost of capital. IRR, on the other hand, computes a break-even rate of return. It shows the discount rate below which an investment results in a positive NPV and above which an investment results in a negative NPV. It is the breakeven discount rate, the rate at which the value of cash outflows equals the value of cash inflows.

##### Solution Summary

The problem set deals with estimating the net present value, internal rate of return and NPV profile of provided financial information.

Solution provided by:
###### Education
• B. Sc., University of Nigeria
• M. Sc., London South Bank University
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