University of the West Indies

Department of Management Studies

MS61T Corporate Finance

Capital Budgeting: Introduction - Chapter 10

 

  1. Why is the capital budgeting decision such an important process?

  2. Why are cash flows used rather than accounting profits in making capital budgeting decisions?

  3. What are the advantages and disadvantages of the internal rate of return method?  

  4. 10-1

  5. 10-2

  6. 10-3

  7. 10-4

  8. 10-5

  9. A firm is considering three separate projects, each having an initial cash outlay of

10,000. The cash flow for Project A is $4,000 per year for three years. The cash flow for Project B is $2,000 each year for years 1 and 3 and $8,000 in year 2. Project C has a cash flow of $10,000 in year 1, followed by $1,000 each year for years 2 and 3.

a.          Use the payback method to calculate how many years it will take for each project to recover the initial investment.

b.         Which project would be considered the most liquid?

  1. 10-7

  2. King Wrecker Co. is considering the purchase of a new tow truck. The cost of the truck is $17,291.42 and the expected incremental cash flows are $5,000 at the end of year 1, $8,000 at the end of year 2, and $10,000 at the end of year 3. 

a.            Calculate the net present value (NPV) if the required rate of return is 12 percent.

b.            Calculate the profitability index (P1).

c.            Calculate the internal rate of return (IRR).

d.         Should the company purchase this truck?

  1. A firm is considering two mutually exclusive projects. Project V will involve an investment of $100,000 and is expected to return net cash flows of $22,611 per year for the next seven years. Project W will cost the firm $300,000 and the expected net cash flows are $63,655 each year from years 1 through 7. The firm has a cost of capital of 12%.

 a.            Calculate the NPV for each project.

b.            Calculate the PI for each project.

c.            Calculate the IRR for each project.

d.         Which project should the firm choose? Why?

e.          Is there a conflict between the decisions indicated by the NPVs and the IRRs?

  1. Hanover Publishers need to purchase a laser printer. The cash flows associated with two possible printers are given below:

  Expected Net Cash  Flows
Year   Printer 1  Printer 2
0  $(2,000) $(2,500)
1 900 1,500
2 1,100 1,300
3 1,300 800

a..            Calculate the payback period for each printer.

b.            Calculate the NPV for each printer if the firm’s cost of capital is 10%.

c.            Calculate the IRR for each printer.

d.         Which printer should be selected? Why?

e.            Suppose the firm’s requires rate of return was 16%, does the decision about which printer to purchase change?

  1. 10-8

  2. 10-9

  3. The product development managers at Coco are about to recommend their final capital budget for next year. They have a budget limit of $100,000. Five independent projects are being considered. Given the following summary of the 5 projects, which ones should the managers recommend? 

Project Initial Outlay Net Present Value
1  $(10,000) $4,000
2 (25,000)   3,600
3 (35,000)  3,250
4  (40,000)  2,500
5 (20.000) 2.100

  1. 10-13

  2. 10-14

  3. 10-19 (except part d.)

  4. 10-21

  5. 10-23 (except part f.)