# Capital Budgeting - NPV, Payback Period

7. X-treme Vitamin Company is considering two investments, both of which cost $10,000. The cash flows are as follows:

Year Project A Project B

1 . . . . . . . . . . $12,000 $10,000

2 . . . . . . . . . . 8,000 6,000

3 . . . . . . . . . . 6,000 16,000

a. Which of the two projects should be chosen based on the payback method?

b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.

c. Should a firm normally have more confidence in answer a or answer b?

15. The Danforth Tire Company is considering the purchase of a new machine that

would increase the speed of manufacturing and save money. The net cost of this

machine is $66,000. The annual cash flows have the following projections.

Year Cash Flow

1. . . . . . . . . $21,000

2. . . . . . . . . 29,000

3. . . . . . . . . 36,000

4. . . . . . . . . 16,000

5. . . . . . . . . 8,000

a. If the cost of capital is 10 percent, what is the net present value?

b. What is the internal rate of return?

c. Should the project be accepted? Why?

20. Miller Electronics is considering two new investments. Project C calls for the purchase of a coolant recovery system. Project H represents an investment in a heat recovery system. The firm wishes to use a net present value profile in comparing the projects. The investment and cash flow patterns are as follows:

Project C Project H

($25,000 investment) ($25,000 investment)

Year Cash Flow Year Cash Flow

1 . . . . . . . . . . . . . .$ 6,000 1 . . . . . . . . . . . . . . .$20,000

2 . . . . . . . . . . . . . . .7,000 2 . . . . . . . . . . . . . . . . .6,000

3 . . . . . . . . . . . . . . .9,000 3 . . . . . . . . . . . . . . . . .5,000

4 . . . . . . . . . . . . . .13,000

a. Determine the net present value of the projects based on a zero discount rate.

b. Determine the net present value of the projects based on a 9 percent discount rate.

c. The internal rate of return on Project C is 13.01 percent, and the internal rate of return on Project H is 15.68 percent. Graph a net present value profile for the two investments similar to Figure 12-3. (Use a scale up to $10,000 on the vertical axis, with $2,000 increments. Use a scale up to 20 percent on the horizontal axis, with 5 percent increments.)

Chapter 13 Problems

1. Myers Business Systems is evaluating the introduction of a new product. The

possible levels of unit sales and the probabilities of their occurrence are given

below:

Possible Sales

Market Reaction in Units Probabilities

Low response . . . . . . . . . . . . . 20 .10

Moderate response . . . . . . . . . 40 .30

High response . . . . . . . . . . . . . 55 .40

Very high response . . . . . . . . . 70 .20

a. What is the expected value of unit sales for the new product?

b. What is the standard deviation of unit sales?

5. Five investment alternatives have the following returns and standard deviations of returns.

Returns- Standard

Alternative Expected Value Deviation

A. . . . . . . . . . $ 5,000 $1,200

B. . . . . . . . . . . 4,000 600

C. . . . . . . . . . . 4,000 800

D. . . . . . . . . . . 8,000 3,200

E. . . . . . . . . . . 10,000 900

Using the coefficient of variation, rank the five alternatives from lowest risk to highest risk.

14. Mr. Monty Terry, a real estate investor, is trying to decide between two potential small shopping center purchases. His choices are the Wrigley Village and Crosley Square. The anticipated annual cash inflows from each are as follows:

Wrigley Village Crosley Square

Yearly Aftertax Yearly Aftertax

Cash Inflow Cash Inflow

(in thousands) Probability (in thousands) Probability

$10 . . . . . . . . . . . .1 $20 . . . . . . . . . . . .1

30 . . . . . . . . . . . .2 30 . . . . . . . . . . . .3

40 . . . . . . . . . . . .3 35 . . . . . . . . . . . .4

50 . . . . . . . . . . . .3 50 . . . . . . . . . . . .2

60 . . . . . . . . . . . .1

a. Find the expected value of the cash flow from each shopping center.

b. What is the coefficient of variation for each shopping center?

c. Which shopping center has more risk?

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Chapter 12 Problems

7. X-treme Vitamin Company is considering two investments, both of which cost $10,000. The cash flows are as follows:

Year Project A Project B

1 . . . . . . . . . . $12,000 $10,000

2 . . . . . . . . . . 8,000 6,000

3 . . . . . . . . . . 6,000 16,000

a. Which of the two projects should be chosen based on the payback method?

b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.

c. Should a firm normally have more confidence in answer a or answer b?

a. Payback for Project A

Since only $10,000 has to be recovered in year 1, while the cash inflow for year 1 = $12,000, then to calculate the fraction of year 1 in which the investment would be recovered:

$10,000/$12,000 = 0.833 Years = 10 months

Payback for Project B

$10,000 - $10,000 1 year

Choose project A

b. NPV for Project A

Year Cash flow Present value @ 10%

1 $12,000 $10,909.2

2 8,000 6,611.2

3 6,000 4,507.8

Present value of inflows $22,028.2

Initial investment 10,000

NPV (net present value) $ 12,028.2

NPV for Project B

Year Cash flow Present value @ 10%

1 $10,000 $9,091

2 6,000 4,958.4

3 16,000 12,020.8

Present value of inflows $26,070.2

Initial investment 10,000

NPV (net present value) $ 16,070.2

Both projects are attractive, but project B adds the most value to the firm. It has the higher NPV.

c. The NPV is preferred and gives more confidence because it incorporates the time value of money and considers all the cash flows.

15. The Danforth Tire Company is considering the purchase of a new machine that

would increase the speed of manufacturing and save money. The net cost of this

machine is $66,000. The annual cash flows have the following projections.

Year Cash Flow

1. . . . . . . . . $21,000

2. . . . . . . . . 29,000

3. . . . . . . . . 36,000

4. . . . . . . . . 16,000

5. . . . . . . . . 8,000

a. If the cost of capital is 10 percent, what is the net present value?

b. What is the internal rate of return?

c. Should the project be ...

#### Solution Summary

The solution is an answer to some Financial Management Problems (Capital Budgeting, NPV, Payback Period) for a variety of fictional organizations.