The managers of United Med tronics are evaluating the following four projects for the coming budget period. The firm's corporate cost of capital is 14 percent.
Project Cost IRR
A $20,000 17%
B $15,000 16%
C $12,000 15%
D $18,000 13%
a. What is the firm's optimal capital budget?
b. Now, suppose Medtronic's managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below-average risk, C has above-average risk, and D has average risk. What is the firm's optimal capital budget when differential risk is considered? (Hint: The firm's managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk projects by the same amount.)
c. Return to the original assumption that all projects have average risk. If United Medtronics are only approved for $30,000 towards their project budget, which project or projects would you accept? (Hint: Any money not used for a project will not receive any return).
The MIT Whitehead Institute must choose between two cDNA microarray machines to expand their high-throughput genomic laboratory. Both of these machines have the same function, and the firm will only choose on vendor from which to purchase their machines.
The first machine, manufactured by Amersham Pharmacia (machine 1), will cost $250,000. The second machine, manufactured by PE Applied Bio systems (machine 2), will cost $200,000.
The cost of capital for both of these investments is 10%. The life for both machines is estimated to be 5 years. During this period, cash flows for machine 1 will be $80,000 per year and cash flows for machine 2 will be $65,000 per year. These cash flows include depreciation expenses. Calculate NPV and IRR for each machine and select the best choice for the MIT Whitehead Institute.
Solutions to given problems depict the steps to calculate IRR, NPV and optimal budget.