# Capital Budgeting Questions

Problem 1

The treasurer of Amaro Canned Fruits Inc. has projected the cash flows of projects A, B and C as follows:

Year Project A Project B Project C

0 -$100,000 -$200,000 -$100,000

1 $ 70,000 $130,000 $ 75,000

2 $ 70,000 $130,000 $ 60,000

Suppose the relevant discount rate is 12 percent a year:

a. Compute the profitability indices for each of the three projects.

b. Compute NPV for each of the three projects.

c. Suppose these three projects are independent. Which projects should Amaro accept based on the profitability index rules?

d. Suppose these three projects are mutually exclusive. Which projects should Amaro accept based on the profitability index rule?

e. Suppose Amaro's budget for these projects is $300,000. The projects are not divisible. Which projects should Amaro accept?

Problem 2

Consider the following cash flows on two mutually exclusive projects for the Bahamas Recreation Corporation (BRC). Both projects require an annual return of 15 percent.

Year Deepwater Fishing New Submarine Ride

0 -$600,000 -$1,800,000

1 $270,000 $1,000,000

2 $350,000 $ 700,000

3 $300,000 $ 900,000

A financial analysis for BRC asked the following questions:

a. Based on the discount pay-back period rule, which project should be chosen?

b. If your decision rule is to accept the project with the greater IRR, which project should you chose?

c. Since you are fully aware of the IRR rules scale problem, you calculate the incremental IRR for the cash flows based on your computations, which project should you choose?

d. To be prudent, you compute the NPV for both projects, which project should you choose? Is it consistent with the incremental IRR rule?

#### Solution Preview

1. a. Compute the profitability indices for each of the three projects.

The profitability index has been computed and is in the attached file.

b. Compute NPV for each of the three projects.

The NPV has been computed and is in the attached file

c. Suppose these three projects are independent. Which projects should Amaro accept based on the profitability index rules?

If the projects are independent, then those projects should be taken up which have a profitability index >= 1. In the given case, all the projects have a profitability index of >1 and hence Amaro should take up all the three projects

d. Suppose these three projects are mutually exclusive. Which projects should Amaro ...

#### Solution Summary

The solution has two questions relating to NPV, IRR and payback calculations