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Capital Budgeting Principles

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1) Each of the following investment opportunities would cost $55,000. Using the following information, calculate the payback period for each proposed investment. In addition, which project would you select based on the payback method of analysis? Why? Finally, what short comings do you see with the payback method of analysis?

Year Project A Project B

1 $5,000 $25,000
2 5,000 17,000
3 10,000 17,000
4 15,000 0
5 15,000 0
6 25,000 0

2) The Management of Ink's Inc. is evaluating the following investment opportunity which will cost the firm $81,383.53 if undertaken. In addition, it is projected that the following after-tax returns will be generated from the project.

Year Cash Flow

1 $20,000
2 25,000
3 30,000
4 35,000

What will the NPV be on the proposed project based on a weighed average cost of capital of 9%? Additionally, what will the project's IRR be?

3) Pilot Corporation has the following current capital structure, which is considered optimal:

Bank Loans $25,000
Bonds $35,000
Preferred Stock $65,000
Common Stock $80,000

Pilot is paying interest at a rate of 12% on its' outstanding loans, a 10% rate of return on its' outstanding bonds, a 12% rate of return on its' preferred stock, and its' common stockholders require an 8% rate of return. The firms' marginal tax rate is 40%. Based on the information provided, calculate the firms' weighted average cost of capital. In addition, explain what a firms' weighted average cost of capital represents. Finally, how is the firms' weighted average cost of capital utilized by management?

1) Tech Pro Inc. is investigating the feasibility of introducing a new high tech baseball bat. Based on research, conducted by the firm, unit sales are projected to be as follows:

Year Unit Sales

1 5,000
2 6,000
3 7,000
4 8,000

The new bat would be priced at $225.00 per unit. The variable cost per unit will be $110.00, and fixed cost will be $42,000.00 per year. The new bat will require $30,000.00 in new net working capital at the start.

It will cost $780,000.00 to buy the equipment necessary to begin production. In addition, the equipment will cost $40,000.00 to setup. The equipment will be classified as three year MACRS property. The equipment will have a salvage value of $10,000.00 at the end of the four years. The firms marginal tax rate is 35% and its' weighted average cost of capital is 12%. Using the NPV method of analysis, determine whether the firm should undertake the proposed project. Why or why not? Bonus, what is the IRR on the proposed project?

Additional information: Depreciation Table

Year 3 Year Property

1 33.33%
2 44.44%
3 14.82%
4 7.41%

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Solution Preview

The payback period of an investment project tells us the number of years required to recover our initial cash investment. In other words, it is the length of the time required for a proposal to 'break even' on its net investment
Initial Investment = $55000
Project A
Year Project A
1 $5000
2 5000
3 10000
4 15000
5 15000
6 25000

In first 5 years, amount recovered = $50000
Amount left to be recovered = $55000 - $50000 = $5000
Cash Inflow in 6th year = $25000
Therefore, Payback Period = 5 + (5000/25000) = 5.2 years
Project B
Year Project B
1 $25000
2 17000
3 17000
4 0
5 0
6 0

In first 2 years, amount recovered = $42000
Amount left to be recovered = $55000 - $42000 = $13000
Cash Inflow in 3rd year = $17000
Therefore, Payback Period = 2 + (13000/17000) = 2.76 years

On the basis of the analysis, since the payback period of Project B is lesser than that of Project A, Project B should be selected. This is because; the money invested in Project B will be recovered much faster than in Project A.
Shortcomings with the payback method of analysis can be concluded as follows:
1) It ignores the cash flows after the payback period. For example, the payback period for the two proposals may be same but one proposal may provide no cash flows afterwards and one proposal may provide some cash flows after the payback period.
2) It ignores the time value of money. It considers the same amount of inflow at different points of time as having same value.
3) It ignores the salvage value and the total economic life of the proposal.
4) It is a measure of capital recovery rather than profitability.
5) It fails to differentiate investments on the basis of the spread of cash flows over the years. For example, in the above problem, the result will not be favourable for a person who prefers returns over the lifetime of the investment and not immediately in first few years. In that case, Project A may be more preferable than Project B.

Net Present Value is defined as the sum total of the present value of all the future cash flows of a proposal
Since the weighted average cost of capital is 9%, same will be used as the discount rate for calculating NPV.
Year Cash Flow PVF(9% n) Present Value of Cash Flows
0 -81,383.53 1 ...

Solution Summary

Capital budgeting principles are examined. The payback methods of analysis are determined.

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Problem 9-2:
A company is 40% financed by risk-free debt. The interest rate is 10%, the expected market risk premium is 8%, and the beta of the company's common stock is .5.

Risk Free Debt Interest Rate Market Risk Premium Beta Taxes
40% 10% 8% 0.5 35%

a.      What is the company cost of capital?
b.      What is the after-tax WACC, assuming that the company pays tax at a 35% rate?

Problem 9-16:
What types of firms need to estimate industry asset betas? How would such a firm make the estimate? Describe the process step by step.

Problem 10-2:
Explain how each of the following actions or problems can distort or disrupt the capital budgeting process. a. Overoptimism by project sponsors.
b. Inconsistent forecasts of industry and macroeconomic variables.
c. Capital budgeting organized solely as a bottom-up process.

Problem 10-14:
Suppose that the expected variable costs of Otobai's project are ¥33 billion a year and that fixed costs are zero. How does this change the degree of operating leverage (DOL)? Now recompute the operating leverage assuming that the entire ¥33 billion of costs are fixed.

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