CAPITAL BUDGETING: PRACTICE QUESTIONS

QUESTION 1 (BH-539)

B. Davis Industries must choose between a gas-powered and an electric-powered forklift

truck for moving materials in its factory. Since both forklifts perform the same function, the
firm will choose only one. (They are mutually exclusive investments.) The electric- powered
truck will cost more, but it will be less expensive to operate; it will cost $22,000, whereas the
gas-powered truck will cost $17,500. The cost of capital that applies to both investments is 12
percent. The life for each type of truck is estimated to be 6 years, during which time the net
cash flows for the electric-powered truck will be $6,290 per year and those for the gas-
powered truck will be $5,000 per year. Annual net cash flows include depreciation expenses.

Required

Calculate the NPV and IRR for each type of truck, and decide which to recommend.
Electric-powered:

NPVE = -$22,000 + $6,290 [(1/i)-(1/(i*(1+i)n)]

= -$22,000 + $6,290 [(1/0.12)-(1/(0.12*(1+0.12)6)]

= -$22,000 + $6,290(4.1114) = -$22,000 + $25,861 = $3,861.

Financial calculator: Input the appropriate cash flows into the cash flow register, input I =
12, and then solve for NPV = $3,861.

Financial calculator: Input the appropriate cash flows into the cash flow register and then
solve for IRR = 18%.

Gas-powered:

NPVG = -$17,500 + $5,000 [(1/i)-(1/(i*(1+i)n)]

= -$17,500 + $5,000 [(1/0.12)-(1/(0.12*(1+0.12)6)]

= -$17,500 + $5,000(4.1114) = -$17,500 + $20,557 = $3,057.

Financial calculator: Input the appropriate cash flows into the cash flow register, input I =
12, and then solve for NPV = $3,057.

Financial calculator: Input the appropriate cash flows into the cash flow register and then
solve for IRR = 17.97% ≈ 18%.

The firm should choose the electric-powered forklift because it has a higher NPV & a higher IRR.
QUESTION 2 (BH-539)

The Costa Rican Coffee Company is evaluating the within-plant distribution system for its
new roasting, grinding, and packing plant. The two alternatives are (1) a conveyor system
with a high initial cost but low annual operating costs and (2) several forklift trucks, which
cost less but have considerably higher operating costs. The decision to construct the plant has
already been made, and the choice here will have no effect on the overall revenues of the
project. The cost of capital for the plant is 9 percent, and the projects’ expected net costs are
listed below:

EXPECTED NET CASH COSTS

YEAR CONVEYOR FORKLIFT

0 (300,000) (120,000)
1 (66,000) (96,000)
2 (66,000) (96,000)
3 (66,000) (96,000)
4 (66,000) (96,000)
5 (66,000) (96,000)

Required

a. What is the IRR of each alternative?

b. What is the present value of costs of each alternative? Which method should be
chosen?

Conveyor:

CF0 = -300000
CF1-CF5 = -66000
I=9
compute NPV = ($ 556717) or the Net Present Cost is $556717
compute IRR = no solution. You can't get an IRR with only negative cash flows (with just costs)

Forklift:

CF0 = -120000
CF1-CF5 = -96000
I=9
compute NPV = -493407. or the present value of cost is $493407
compute IRR = no solution. Same reason as above

Thus the forklift has a lower Net Present Cost by the following amount: $5556717-$493407=$63310.

To calculate an IRR the cash flows must include the inflows (returns) to the project as well as the
cost.
QUESTION 3 (BH-537)

A firm has $100 million available for capital expenditures. It is considering investing in one
of two projects; each has a cost of $100 million. Project A has an IRR of 20 percent and an
NPV of $9 million. It will be terminated at the end of 1 year at a profit of $20 million,
resulting in an immediate increase in earnings per share (EPS). Project B, which cannot be
postponed has an IRR of 30 percent and an NPV of $50 million. However, the firm’s short
run EPS will be reduced if it accepts Project B, because no revenues will be generated for
several years.

Required

a. Should the short-run effects on EPS influence the choice between the two projects?

b. How might situations like the one described here influence a firm’s decision to use
payback as a part of the capital budgeting process?

QUESTION 4 (BH-540)

After discovering a new gold vein in the Colorado Mountains, CTC Mining Corporation must
decide whether to mine the deposit. The most cost-effective method of mining gold is sulfuric
acid extraction, a process that results in environmental damage. To go ahead with the
extraction, CTC must spend $900,000 for new mining equipment and pay $165,000 for its
installation. The gold mined will net the firm an estimated $350,000 each year over the 5-
year life of the vein. CTC’s cost of capital is 14 percent. For the purposes of this problem,
assume that the cash inflows occur at the end of the year.

Required

a. What are the NPV and IRR of this project?

b. Should this project be undertaken, ignoring environmental concerns?

c. How should environmental effects be considered when evaluating this, or any other,
project? How might these effects change your decision in part b?

A) cash flow from the proposed minings:

Year
1 -$165,000
0 350,000
2 350,000
3 350,000
4 350,000
5 350,000
NPV = $136,578.34 and IRR= 19.22%

b) Yes , since NPV is 0 (ans IRR>WACC)

c) THe analysis in (a) ignores the environmental damage caused by the mining
process.Envronmrntal damage is an example of externality. The firm should deduct the
cost of it from the expected cash flows to get a better estimates of marginal benefits and
costs. If environemental costs are large enough then it may lead the manager to quit the
project in hand.
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QUESTION 5 (BH-540)

Sharon Evans, who graduated from the local university 3 years ago with a degree in
marketing, is manager of Ann Naylor’s store in the Southwest Mall. Sharon’s store has 5
years remaining on its lease. Rent is $2,000 per month, 60 payments remain, and the next
payment is due in 1 month. The mall’s owner plans to sell the property in a year and wants
rents at that time to be high so the property will appear more valuable. Therefore, Sharon has
been offered a “great deal” (owner’s words) on a new 5-year lease. The new lease calls for
zero rent for 9 months, then payments of $2,600 per month for the next 51 months. The lease
cannot be broken, and Ann Naylor Corporation’s cost of capital is 12 percent (or 1 percent
per month). Sharon must make a decision. A good one could help her career and move her up
in management, but a bad one could hurt her prospects for promotion.
Required

a. Should Sharon accept the new lease? (Hint: Be sure to use 1 percent per month.)

b. Suppose Sharon decided to bargain with the mall’s owner over the new lease payment.
What new lease payment would make Sharon indifferent between the new and the old
leases? (Hint: Find FV of the first 9 payments at t _ 9, then treat this as the PV of a 51-
period annuity whose payments represent the incremental rent during Months 10 to
60.)

c. Sharon is not sure of the 12 percent cost of capital—it could be higher or lower. At
what nominal cost of capital would Sharon be indifferent between the two leases?
(Hint: Calculate the differences between the two payment streams, and find the IRR of
this difference stream.)

QUESTION 6 (BH-542)

Your division is considering two investment projects, each of which requires an up-front
expenditure of $25 million. You estimate that the cost of capital is 10 percent and that the
investments will produce the following after-tax cash flows (in millions of dollars):

Year Project A Project B

1 5 20
2 10 10
3 15 8
4 20 6

Required
a. What is the regular payback period for each of the projects?

b. What is the discounted payback period for each of the projects?

c. If the two projects are independent and the cost of capital is 10 percent, which project or
projects should the firm undertake?

d. If the two projects are mutually exclusive and the cost of capital is 5 percent, which
project should the firm undertake?

e. If the two projects are mutually exclusive and the cost of capital is 15 percent, which
project should the firm undertake?

f. What is the crossover rate?

g. If the cost of capital is 10 percent, what is the modified IRR (MIRR) of each project?

QUESTION 7

The treasurer of Orient Express, Inc., has projected the cash flows of projects A, B, and C as
follows. Suppose the relevant discount rate is 12 percent a year.

Year Project A Project B Project C

0 (100,000) (200,000) (100,000)
1 70,000 130,000 75000
2 70,000 130,000 60,000

Required

a. Compute the NPVs for each of the three projects.

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

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

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

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

QUESTION 8 (BM- 27)

A parcel of land costs $500,000. For an additional $800,000 you can build a motel on the
property. The land and motel should be worth $1,500,000 next year. Suppose that common
stocks with the same risk as this investment offer a 10 percent expected return. Would you
construct the motel? Why or why not?

QUESTION 9 (BM-28)

In Section 2.1, we analyzed the possible construction of an office building on a plot of land
appraised at $50,000. We concluded that this investment had a positive NPV of $7,143 at a
discount rate of 12 percent. Suppose E. Coli Associates, a firm of genetic engineers, offers to
purchase the land for $60,000, $30,000 paid immediately and $30,000 after one year. United
States government securities maturing in one year yield 7 percent.

Required

a. Assume E. Coli is sure to pay the second $30,000 installment. Should you take its offer
or start on the office building? Explain.
b. Suppose you are not sure E. Coli will pay. You observe that other investors demand a
10 percent return on their loans to E. Coli. Assume that the other investors have
correctly assessed the risks that E. Coli will not be able to pay. Should you accept E.
Coli’s offer?

QUESTION 10 (BM-28)

Norman Gerrymander has just received a $2 million bequest. How should he invest it? There
are four immediate alternatives.

Required

a. Investment in one-year U.S. government securities yielding 5 percent.

b. A loan to Norman’s nephew Gerald, who has for years aspired to open a big Cajun
restaurant in Duluth. Gerald had arranged a one-year bank loan for $900,000, at 10
percent, but asks for a loan from Norman at 7 percent.

c. Investment in the stock market. The expected rate of return is 12 percent.

d. Investment in local real estate, which Norman judges is about as risky as the stock
market. The opportunity at hand would cost $1 million and is forecasted to be worth
$1.1 million after one year. Which of these investments have positive NPVs? Which
would you advise Norman to take?

e. Suppose a bank offers Norman a $600,000 personal loan at 8 percent. (Norman is a

long-time customer of the bank and has an excellent credit history.) Suppose Norman
borrows the money, invests $1 million in real estate opportunity (d) and puts the rest of
his money in opportunity (c), the stock market. Is this a smart move? Explain.
QUESTION 11 (BM-28)

Comment on the following

a. “My company’s cost of capital is the rate we pay to the bank when we borrow money.”

b. “Net present value is just theory. It has no practical relevance. We maximize profits.
That’s what shareholders really want.”

c. “It’s no good just telling me to maximize my stock price. I can easily take a short view
and maximize today’s price. What I would prefer is to keep it on a gently rising trend.”

QUESTION 12 (BM-51)

Solve the following

a. The cost of a new automobile is $10,000. If the interest rate is 5 percent, how much
would you have to set aside now to provide this sum in five years?

b. You have to pay $12,000 a year in school fees at the end of each of the next six years.
If the interest rate is 8 percent, how much do you need to set aside today to cover these
bills?

c. You have invested $60,476 at 8 percent. After paying the above school fees, how much
would remain at the end of the six years?

QUESTION 13 (BM-52)

Halcyon Lines is considering the purchase of a new bulk carrier for $8 million. The
forecasted revenues are $5 million a year and operating costs are $4 million. A major refit
costing $2 million will be required after both the fifth and tenth years. After 15 years, the ship
is expected to be sold for scrap at $1.5 million. If the discount rate is 8 percent, what is the
ship’s NPV?

QUESTION 14 (BM-53)

As winner of a breakfast cereal competition, you can choose one of the following prizes:

a. $100,000 now.

b. $180,000 at the end of five years.

c. $11,400 a year forever.

d. $19,000 for each of 10 years.

e. $6,500 next year and increasing thereafter by 5 percent a year forever.

If the interest rate is 12 percent, which is the most valuable prize?

QUESTION 15 (BM-112)

Solve the following:

a. What is the payback period on each of the following projects?

Cash Flows
Project C0 C1 C2 C3 C4
A –5,000 1,000 1,000 3,000 0
B –1,000 0 1,000 2,000 3,000
C –5,000 1,000 1,000 3,000 5,000

c. Given that you wish to use the payback rule with a cutoff period of two years, which
projects would you accept?

d. If you use a cutoff period of three years, which projects would you accept?

e. If the opportunity cost of capital is 10 percent, which projects have positive NPVs?

f. “Payback gives too much weight to cash flows that occur after the cutoff date.” True or
false?

g. “If a firm uses a single cutoff period for all projects, it is likely to accept too many
short-lived projects.” True or false?

h. If the firm uses the discounted-payback rule, will it accept any negative-NPV projects?
Will it turn down positive-NPV projects? Explain.