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# Capital Budgeting Parameters Calculations

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P8-1. Suppose that a thirty-year Treasury bond offers a 4% coupon rate, paid semiannually. The market price of the bond is \$1,000, equal to its par value.
c. What is the discounted payback period for the bond, assuming its 4% coupon rate is the required return? What general principle does this example illustrate regarding a project's life, its discounted payback period, and its NPV?

P8-4. Calculate the NPV for the following twenty-year projects. Comment on the acceptability of each. Assume that the firm has an opportunity cost of 14%.
a. Initial cash outlay is \$15,000; cash inflows are \$13,000 per year.
b. Initial cash outlay is \$32,000; cash inflows are \$4,000 per year.
c. Initial cash outlay is \$50,000; cash inflows are \$8,500 per year.

P8-9. A certain investment requires an initial outlay of \$12 million and subsequently produces annual cash inflows of \$1.4 million in perpetuity. A firm evaluating this investment uses a discount rate of 10%. What is the investment's NPV? What is the EVA each period? What is the present value of the stream of EVAs?

P10-1. Puritan Motors has a capital structure consisting almost entirely of equity.
a. If the beta of Puritan stock equals 1.6, the risk-free rate equals 6%, and the expected return on the market portfolio equals 11%, then what is the cost of equity?
b. Suppose that a 1% increase in expected inflation causes a 1% increase in the risk-free rate. Holding all other factors constant, what will this do to the firm's cost of equity? Is it reasonable to hold all other factors constant? What other part of the calculation of the cost of equity is likely to change if the expected inflation rises?

P10-3. In its 2009 annual report, The Coca-Cola Company reported sales of \$30.99 billion for fiscal year 2009 and \$31.94 billion for fiscal year 2008. The company also reported operating income (roughly equivalent to EBIT) of \$8.23 billion in 2009 and \$8.45 billion in 2008. Meanwhile, arch rival PepsiCo, Inc., reported sales of \$43.23 billion in 2009 and \$43.25 billion is 2008. PepsiCo's operating income was \$8.04 billion in 2009 and \$6.96 billion in 2008. Based on these figures, which company had higher operating leverage?

#### Solution Preview

P8-1. Suppose that a thirty-year Treasury bond offers a 4% coupon rate, paid semiannually. The market price of the bond is \$1,000, equal to its par value.

c. What is the discounted payback period for the bond, assuming its 4% coupon rate is the required return? What general principle does this example illustrate regarding a project's life, its discounted payback period, and its NPV?

In this case required rate of return is equal to coupon rate, discounted payback period will be equal to its maturity period i.e. 30 years.
It shows that the projects which pay late in the life of project investment are more disadvantageous under discounted payback period than under regular payback period. Discounted payback period is higher in such cases. It is better to use NPV to determine value of investment proposals.

P8-4. Calculate the NPV for the following twenty-year projects. Comment on the acceptability of each. Assume that the firm has an opportunity cost of 14%.

a. Initial cash outlay is \$15,000; cash inflows are \$13,000 per year.
First we calculate PV of cash inflows
Initial cash outflow=Co=-\$15000
Periodic cash flow=R=\$13000
Opportunity cost=i=14%
Number of periods=n=20
PV of cash ...

#### Solution Summary

Solutions to given problems demonstrate the step by step methodology to find out the value of desired parameter. Over 700 words total.

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## Calculate the accounting rate of return, payback period, NPV and IRR measures for given machines.

Sea Cable Industries is a company involved in the manufacture of marine cables. The company is planning a move into land lines to exploit new telecommunications opportunities. This will involve the acquisition of new equipment. Two machines have been identified and the returns involved in purchasing each are as follow:

Machine 1 Machine 2
Rand Rand
Cost (Immediate outlay) 200 000 120 000
Expected annual net Profit/Loss
Year 1 60 000 33 000
Year 2 (2000) (12 000)
Year 3 8000 12000
Year 3 Estimated residual value 14000 12000

The company has an estimated cost of capital of 10% and utilizes the straight line method of depreciation. Sea Cable Industries minimum accounting rate of return is 18% and the maximum payback period is 2 years and 4 months. You should assume that the two machines are mutually exclusive.

Required:
1 Calculate the accounting rate of return for each machine, assess its acceptability and indicate which machine is better using the accounting rate of return.
2 Calculate the payback period for each machine, assess its acceptability and indicate which machine is better using the payback period.
3 Calculate the net present value (NPV) of each machine, assess its acceptability and indicate which machine is better using NPV.
4 Calculate the internal rate of return (IRR) of each machine, assess its acceptability and indicate which machine is better using IRR.
5 Which method of investment appraisal is most appropriate and give reasons.

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