a. Capital Budgeting is the process in which a business whether projects are worth pursuing such as investing or building new facilities. This can include anything from new plants to research tools and even capital expenditures.
b. When a project is independent, the cash flows are independent on one another whereas a mutually exclusive project means that if one project is taken on, the other cannot be done.
c. 1. Net Present Value is the difference between the present value of cash inflows and the present value of cash outflow. It can be used to calculate the profitability of an investment.
Year 0 1 2 3
Project L -100 10 60 80
Disc. Cash Flows -100 9.09 49.59 60.11
Project S -100 70 50 20 Disc Cash Flows -100 63.64 41.32 15.02
Rate = 10%
Project L NPV = $18.78
Project S NPV = $19.98
2. The rationale behind the NPV method is that an NPV of zero shows that the projects cash flows are exactly sufficient to repay the invested capital and to provide the required rate of return. A positive NPV means that it is generating more cash than is needed to service the debt and provided to shareholders, vice versa for negative NPV. If both projects were independent, you would accept both projects considering the positive NPV. Both projects add to shareholder wealth in that instance. If they were mutually exclusive you would only accept Project L with the higher NPV. 3. Yes, if the cost of capital changed, then the NPV would change considering it is the basis for the NPV.
d. 1. Internal rate of return is the rate of return used in capital budgeting to measure profitability of investments.
Year 0 1 2 3
Project L -100 10 60 80
Project S -100 70 50 20
Project L IRR = 18.13% (using function) WACC= 10%
Project S IRR = 23.56% 2. The YTM is the expected rate of return on a project as it is the rate to be given on a bond. Essentially, they are the same thing. 3. The logic behind the IRR is this: The IRR on a project is its expected rate of return, if the IRR exceeds the cost of the funds used to finance the project, a surplus will remain after paying the capital that will accrues to the stockholders, and taking on a project whose IRR exceeds its cost of capital increases shareholders wealth. If both projects are independent due to the fact that they both exceed the cost of capital should be accepted. If they were mutually exclusive, then we would choose project L with the higher IRR. 4. No, because the IRR is independent of the cost of capital. It is not used in the calculation. However, It does factor in when interpreting the IRR.
e. 1.
WACC Project L (18.78) WACC Project S (19.98)
0% 50.00 0% 40.00
2% 42.86 2% 35.53
4% 36.21 4% 31.32
6% 30.00 6% 27.33
8% 24.21 8% 23.56
10% 18.78 10% 19.98
12% 13.70 12% 16.60
14% 8.94 14% 13.38
16% 4.46 16% 10.32
18% 0.26 18% 7.40
20% -3.70 20% 4.63
22% -7.43 22% 1.98
24% ($10.95) 24% ($0.54) Crossover rate= IRR (60.-10.-60) =8.68% 2. If the projects were mutually exclusive, regardless, project S should be ranked higher due the IRR. A conflict will arise is the rate is less than the crossover point for these projects. As long as the cost of capital is greater than the crossover rate, then we should choose project S. If the projects were independent, the NPV and IRR would lead to the same decisions. If NPV says accept, then IRR also does.
f. 1. The reinvestment rate assumption is the underlying cause of the IRR and NPV ranking conflicts. NPV assumes cash flows are reinvested at the projects cost of capital whereas for IRR, it assumes reinvestment as the IRR rate. 2. The reinvestment rate assumption assumes that the rate at which cash flows can be reinvested is the cost of capital, whereas the IRR method assumes that the firm van reinvest at IRR. 3. The best method is that the projects cash flows can be reinvested at the cost of capital meaning that the NPV method is more reliable. NPV also measures change in
