CAPITAL BUDGETING

PRACTISE QUESTIONS

Question 1: Davis Corporation is faced with two independent investment opportunities. The

corporation has an investment policy which requires acceptable projects to recover all costs

within 3 years. The corporation utilizes a discount rate of 10 percent. The cash flows for the two

projects are:

Year Project A Cash Flows Project B Cash Flows

0 -$ 100,000 -$ 80,000

1 $ 40,000 $ 50,000

2 $ 40,000 $ 20,000

3 $ 40,000 $ 30,000

4 $ 30,000 0

Which investment project(s) does the company invest in?

a. Project A only.

b. Neither Project A nor Project B.

c. Project A and Project B.

d. Project B only.
Question 2: You are considering the purchase of an investment that would pay you $5,000 per

year for Years 1-5, $3,000 per year for Years 6-8, and $2,000 per year for Years 9 and 10. If you

require a 14 percent rate of return, and the cash flows occur at the end of each year, then how

much should you be willing to pay for this investment?

a. $15,819.27

b. $21,937.26

c. $32,415.85

d. $38,000.00

e. $52,815.71

Question 3: The following net cash flows relate to two projects:

NET CASH FLOWS (IN $ 1,000)

YEAR 0 1 2 3 4 5 6
PROJECT A -60 20 20 20 20 20 20
PROJECT B -72 45 22 20 13 13 13

(i) Calculate the NPVs for each project, assuming 10% cost of capital.

(ii) Assuming that the two projects are independent, would you accept them if the cost

of capital is 15%?

(iii) What is the IRR of each project?

(iv) Which of the two projects would you prefer if they are mutually exclusive, given a

15% discount rate?

Question 4: A firm has a capital budget of $100 which must be spent on one of two projects, each

requiring a present outlay of $100. Project A yields a return of $120 after one year, whereas Project

B yields $201.14 after 5 years. Calculate:

(i) the NPV of each project using a discount rate of 10%;

(ii) the IRR of each project.

Question 5: A firm has a capital budget of $100 which must be spent on one of two projects, with

any unspent balance being placed in a bank deposit earning 15%. Project A involves a present

outlay of $100 and yields $321.76 after 5 years. Project B involves a present outlay of $40 and

yields $92 after one year. Calculate:

(i) the IRR of each project;

(ii) the B/C ratio of each project, using a 15% discount rate.

Question 6: A company is considering two projects and can only accept one of them. The

projected cash flows are as follows;

Year Project A Cash Flow Project B Cash Flow

0 -$10,000,000 -$15,000,000

3 $15,000,000 $21,7000,000

The company WACC is 10%. Compute the payback, NPV and IRR for each project. Which project

should be chosen? Explain the logic behind your choice.

Question 7:

Haig Aircraft is considering a project which has an up-front cost paid today at t=0. The project

will generate positive cash flows of $60,000 a year at the end of each of the next five years. The

project’s NPV is $75,000 and the company’s WACC is 10 percent. What is the project’s,

payback?

a. 3.22 years

b. 1.56 years

c. 2.54 years

d. 2.35 years

e. 4.16 years

Question 8:

Your company is choosing between the following non-repeatable equally risky, mutually

exclusive projects with the cash flows shown below. Your cost of capital is 10 percent. How

much value will your firm sacrifice if it selects the project with the higher IRR?

Year Project S Project L

0 -1,000 -2,000

1 500 668.76

2 500 668.76

3 500 668.76

4 - 668.76

5 - 668.76
 (a) $ 243.43

(b) $ 291.70

(c) $ 332.50

(d) $ 481.15

(e) $ 535.13

Question 9: Net Present Value – Swanson Industries has four potential projects all with an initial

cost of $2,000,000. The capital budget for the year will only allow Swanson industries to accept

one of the four projects. Given the discount rates and the future cash flows of each project, which

project should they accept?

Cash Flows Project M Project N Project O Project P

Year one $500,000 $600,000 $1,000,000 $300,000
Year two $500,000 $600,000 $800,000 $500,000
Year three $500,000 $600,000 $600,000 $700,000
Year four $500,000 $600,000 $400,000 $900,000
Year five $500,000 $600,000 $200,000 $1,100,000
Discount Rate 6% 9% 15% 22%
Question 10:

Given the cash flows of the four projects, A, B, C, and D, and using the Payback Period decision

model, which projects do you accept and which projects do you reject with a three year cut-off

period for recapturing the initial cash outflow? Assume that the cash flows are equally

distributed over the year for Payback Period calculations.

Projects A B C D
Cost $10,000 $25,000 $45,000 $100,000
Cash Flow Year One $4,000 $2,000 $10,000 $40,000
Cash Flow Year Two $4,000 $8,000 $15,000 $30,000
Cash Flow Year Three $4,000 $14,000 $20,000 $20,000
Cash Flow Year Four $4,000 $20,000 $20,000 $10,000
Cash Flow year Five $4,000 $26,000 $15,000 $0
Cash Flow Year Six $4,000 $32,000 $10,000 $0

Question 11:

Profitability Index -- Given the discount rates and the future cash flows of each project, which

projects should they accept using profitability index?

Cash Flows Project U Project V Project W Project X

Year zero -$2,000,000 -$2,500,000 -$2,400,000 -$1,750,000
Year one $500,000 $600,000 $1,000,000 $300,000
Year two $500,000 $600,000 $800,000 $500,000
Year three $500,000 $600,000 $600,000 $700,000
Year four $500,000 $600,000 $400,000 $900,000
Year five $500,000 $600,000 $200,000 $1,100,000
Discount Rate 6% 9% 15% 22%