Ma. Theresa M.

Mamauag
MBA – 704

I. ST-1 KEY TERMS: Define the following terms:

a. Capital Budgeting - It is the process a business undertakes to evaluate potential major

projects or investments. The process can involve almost anything including acquiring
land or purchasing fixed assets like a new truck or machinery.
Strategic Business Plan - It is a series of logical and creative steps to identify the long-
term business objectives ranked by importance. It is a complex process of collecting
information, analyzing input data and conducting internal and external assessments of
available business resources.
b. Net Present Value – It is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital
budgeting and investment planning to analyze the profitability of a projected investment
or project.
c. Internal Rate of Return (IRR) – It is a metric used in capital budgeting to estimate the
profitability of potential investments. The internal rate of return is a discount rate that
makes the net present value (NPV) of all cash flows from a particular project equal to
zero. IRR calculations rely on the same formula as NPV does.
d. NPV Profile – It is a graph of the project’s net present value corresponding to different
values of discount rates. The NPV values are plotted on the Y-axis and the WACC is
plotted on the X-axis.
Crossover Rate - is the rate of return (alternatively called weighted average cost of
capital) at which the Net Present Values (NPV) of two projects are equal. It represents the
rate of return at which the net present value profile of one project intersects the net
present value profile of another project.
e. Mutually Exclusive Projects - It is the term which is used generally in the capital
budgeting process where the companies choose a single project on the basis of certain
parameters out of the set of the projects where acceptance of one project will lead to
rejection of the other projects.
Independent Projects - These are projects whose acceptance or rejection is independent of
the acceptance or rejection of other projects.
f. Non-normal Cash Flow - It is a pattern of cash flows in which the direction of cash flows
changes more than once. It is also termed as unconventional cash flow.
Normal Cash Flow - It is the cash flow stream that comprises of initial investment outlay
and then positive net cash flow throughout the project life. It is also called conventional
cash flow stream.
Multiple IRRs – It occur when a project has more than one internal rate of return. The
problem arises where a project has non-normal cash flow (non-conventional cash flow
pattern).
 g. Modified Internal Rate of Return (MIRR) - It assumes that positive cash flows are
reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's
financing cost. It is a modification of the internal rate of return (IRR) formula, which
resolves some issues associated with that financial measure.
h. Payback Period - It is the time in which the initial outlay of an investment is expected to
be recovered through the cash inflows generated by the investment. It is one of the
simplest investment appraisal techniques.
Discounted Payback Period - It is a variation of payback period which uses discounted
cash flows while calculating the time an investment takes to pay back its initial cash
outflow.

II. EASY PROBLEMS

PROBLEM 11-1. NPV Project K costs $52,125, its expected cash inflows are $12,000 per year
for 8 years, and its WACC is 12%. What is the project's NPV?

Initial Investment = 52,125, Cash Inflow = 12,000, i = 12% = 0.12, n = 8 years

NPV = -$52,125 + $12,000[(1 / i)-(1 / (i*(1+i)n)]

= -$52,125 + $12,000[(1 / 0.12)-(1 / (0.12(1+0.12)8)]

= -$52,125 + $12,000(4.9676)

= $7,486.20.

PROBLEM 11-2. IRR Refer to Problem 11-1. What is the project's IRR?
Initial Investment = 52,125, Cash Inflow = 12,000,

Year Cash Flow Net Cash Flow

0 -52,125 -52,125
1 $12000 -40,125
2 $12000 -28,125
3 $12000 -16,125
4 $12000 -4,125
5 $12000  
6 $12000  
7 $12000  
8 $12000  
IRR = 16%
PROBLEM 11-3. MIRR Refer to Problem 11-1. What is the project's MIRR?

PV = 52,125, PMT = 12,000, i = 12% or 0.12, n = 8 years

FV= PMT[((1 + i )n-1) / i] = 12000[((1 + 0.12 )8-1 / 0.12]

= 12000(12.299)

FV = 147596.31

MIRR = n(FV/PV)-1
= 8(147596.31/52125)-1
= (147596.31 / 52125)1/8-1
= 1.1389 – 1
MIRR = 0.1389 or 13.89%

PROBLEM 11-4. PAYBACK PERIOD Refer to Problem 11-1. What is the project's payback?
Initial Investment = 52,125, Cash Inflow = 12,000
Yea Cash Net Cash
r Flow Flow
0 -52,125 -52,125
1 $12000 -40,125
2 $12000 -28,125
3 $12000 -16,125
4 $12000 -4,125
5 $12000 7,875
6 $12000 19,875
7 $12000 31,875
8 $12000 43,875

Payback = 4 + ($4,125/$12,000)
Payback = 4.34
PROBLEM 11-5. DISCOUNTED PAYBACK Refer to Problem 11-1. What is the project's
discounted payback?
Initial Investment = 52,125, Cash Inflow = 12,000, i = 12%

Year Annual CF Discounted CF (12%) Cumulative Discounted CF

0 -52,125 $-52,125.00 -52,125.00
1 $12000 $10,714.29 -41,410.71
2 $12000 $9,566.33 -31,844.39
3 $12000 $8,541.36 -23,303.02
4 $12000 $7,626.22 -15,676.81
5 $12000 $6,809.12 -8,867.69
6 $12000 $6,079.57 -2,788.11
7 $12000 $5,428.19 2,640.08
8 $12000 $4,846.60 7,486.68

Discounted Payback Period = 6.51 years

PROBLEM 11-6 NPV Your division is considering two projects with the following cash flows
(in millions):
0 1 2 3
Project A -$25 $5 $10 $17
Project B -$20 $10 $9 $6
a. What are the projects' NPVs assuming the WACC is 5%? 10%? 15%?
b. What are the projects' IRRs at each of these WACCs?
c. If the W ACC was 5% and A and B were mutually exclusive, which project would you
choose? What if the WACC was 10%? 15%? (Hint: The crossover rate is 7.81 %).

a. Project A
Year Cash Flow Discount Rate Discounted Cash Flow
0 -25 (1.05)0 -25
1 5 (1.05)1 4.76
2 10 (1.05)2 9.07
3 17 (1.05)3 14.69
NPV = $3.52
 Year Cash Flow Discount Rate Discounted Cash Flow
0 -25 (1.10)0 -25
1 5 (1.10)1 4.55
2 10 (1.10)2 8.26
3 17 (1.10)3 12.77
NPV = $0.58

Year Cash Flow Discount Rate Discounted Cash Flow

0 -25 (1.15)0 -25
1 5 (1.15)1 4.35
2 10 (1.15)2 7.56
3 17 (1.15)3 11.18
NPV = $2.87

Project B

Year Cash Flow Discount Rate Discounted Cash Flow

0 -20 (1.05)0 -20
1 10 (1.05)1 9.53
2 9 (1.05)2 8.16
3 6 (1.05)3 5.18
NPV = $1.04

Year Cash Flow Discount Rate Discounted Cash Flow

0 -20 (1.10)0 -20
1 10 (1.10)1 9.09
2 9 (1.10)2 7.44
3 6 (1.10)3 4.51
NPV = ($0.54)

Year Cash Flow Discount Rate Discounted Cash Flow

0 -20 (1.15)0 -20
 1 10 (1.15)1 8.7
2 9 (1.15)2 6.81
3 6 (1.15)3 3.95
NPV = ($1.91)

b. Project A Project B

Year Cash Flow Year Cash Flow

0 -25 0 -20
1 5 1 10
2 10 2 9
3 17 3 6

IRR = 11.10% IRR = 13.18%

c.

WAC Project Project

C A B
5% $3.52 $2.87
10% $0.58 $1.04
15% -$1.91 -$0.55
IRR 11.10% 13.18%

At 5% WACC, both project's NPV is positive, however, the NPV of project A is greater than that
of project B and the IRR of project B is greater than that of project A. Since two projects are
mutually exclusive, the NPV criterion should be chosen over IRR, and therefore, the project A
should be selected.

At 10% WACC, project B's NPV and IRR is higher than that of project A, and hence, it should
be chosen.

At 15% WACC, the NPV of both projects is negative, and thus, they should not be selected to
invest.
Problem 11-10. CAPITAL BUDGETING CRITERIA: MUTUALLY EXCLUSIVE PROJECTS
A firm with a WACC of 10% is considering the following mutually exclusive projects:

Years 0 1 2 3 4 5
Project A -$400 $55 $55 $55 $225 $225
Project B -$600 $300 $300 $50 $50 $49

Which project would you recommend? Explain.

WACC = 10%
Project A:
NPV = -$400 + 55 / (1 + 10%)1+ 55 / (1 + 10%)2+ 55 / (1 + 10%)3+ 225 / (1 + 10%)4+ 225 / (1
+ 10%)5
NPV= $30.162
Project B:
NPV = -$600 + 300 / (1+10%)1+ 300 / (1+10%)2+ 50 / (1+10%)3+ 50 / (1+10%)4+ 49 /
(1+10%)5
NPV = $22.802

a. What is capital budgeting? Are there any similarities between a firm’s capital budgeting
decisions and an individual’s investment decisions?

Capital budgeting is the process a business undertakes to evaluate potential major projects or
investments. Construction of a new plant or a big investment in an outside venture are examples
of projects that would require capital budgeting before they are approved or rejected. Capital
budgeting is important because, more than anything else, fixed asset investment decisions chart a
company’s course for the future. Conceptually, the capital budgeting process is identical to the
decision process used by individuals making investment decisions. These steps are involved:
1.Estimate the cash flows—interest and maturity value or dividends in the case of bonds and
stocks, operating cash flows in the case of capital projects.
2.Assess the riskiness of the cash flows.
3.Determine the appropriate discount rate, based on the riskiness of the cash flows and the
general level of interest rates. This is called the project cost of capital in capital budgeting.
4.Find (a) the PV of the expected cash flows and/or (b) the asset’s rate of return.
5.If the PV of the inflows is greater than the PV of the outflows (the NPV is positive), or if the
calculated rate of return (the IRR) is higher than the project cost of capital, accept the project.

b. What is the difference between independent and mutually exclusive

projects? Between projects with normal and non-normal cash flows?
A Project whose cash flows have no impact on the acceptance or rejection of other projects is
termed as Independent Project (not mutually exclusive). Thus, all such Projects which meet this
criterion should be accepted.

A set of projects from which at most one will be accepted is termed as Mutually Exclusive
Projects. In mutually exclusive projects, cash flows of one project can be adversely affected by
the acceptance of the other project. In mutually exclusive projects, all projects are to accomplish
the same task. Therefore, such projects cannot be undertaken simultaneously. Hence, while
choosing among Mutually Exclusive Projects, more than one project may satisfy the Capital
Budgeting criterion. However, only one project can be accepted.

Normal cash flows consists of (1) initial negative cash flows (i.e., costs) and (2) subsequent
positive cash flows (i.e., revenues generated from the project or investment).
Non-normal cash flows can have alternating positive and negative cash flows over time. That is,
at any given point in time, a project could have a positive cash flow or a negative cash flows.

c . 1. Define the term net present value (NPV). What is each project’s NPV?
Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and
investment planning to analyze the profitability of a projected investment or project.
Year Cash Flow Discount Rate PV
0 -100 (1.10)0 -100
1 10 (1.10)1 9.09
2 60 (1.10)2 49.59
3 80 (1.10)3 60.11
NPV = 18.79

Year Cash Flow Discount Rate Discounted Cash Flow

0 -100 (1.10)0 -100
1 70 (1.10)1 63.64
 2 50 (1.10)2 41.32
3 20 (1.10)3 15.03
NPV = 19.99

2. What is the rationale behind the NPV method? According to NPV, which project(s)should be
accepted if they are independent? Mutually exclusive?
The rationale behind the NPV method is straightforward: If a project has NPV = $0, then the
project generates exactly enough cash flows (1) to recover the cost of the investment and (2) to
enable investors to earn their required rates of return (the opportunity cost of capital). If NPV =
$0, then in a financial (but not an accounting) sense, the project breaks even. If the NPV is
positive, then more than enough cash flow is generated, and conversely if NPV is negative.
Consider Project L’s cash inflows, which total $150. They are sufficient (1) to return the $100
initial investment, (2) to provide investors with their 10% aggregate opportunity cost of capital,
and (3) to still have $18.78 left over on a present value basis. This $18.78 excess PV belongs to
the shareholders—the debtholders’ claims are fixed—so the shareholders’ wealth will be
increased by $18.78 if Project L is accepted. Similarly, Allied’s shareholders gain $19.98 in
value if Project S is accepted.
If Projects L and S are independent, then both should be accepted, because both add to
shareholders’ wealth, hence to the stock price. If the projects are mutually exclusive, then
Project S should be chosen over L, because S adds more to the value of the firm.
d. 1. Define the term internal rate of return (IRR). What is each project’s IRR?
The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability
of potential investments. The internal rate of return is a discount rate that makes the net present
value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on
the same formula as NPV does.
Project L = $0 if IRR = 18.1% is used as the discount rate.
Project S = IRRS ≈23.6%.
2. How is the IRR on a project related to the YTM on a bond?
The internal rate of return of the project and the YTM of the bond is similar to a slight
distinction. For the IRR of the project, is it the annualized growth rate of the project from its
generated cash flow. Meanwhile, the YTM of the bond is the annualized growth rate of the
bond's cash flow from its coupon payment and maturity value.
3. What is the logic behind the IRR method? According to IRR, which projects should be
accepted if they are independent? Mutually exclusive?
IRR measures a project’s profitability in the rate of return sense: If a project’s IRR equals its
cost of capital, then its cash flows are just sufficient to provide investors with their required rates
of return. An IRR greater than WACC implies an economic profit, which accrues to the firm’s
shareholders, while an RR less than WACC indicates an economic loss, or a project that will not
earn enough to cover its cost of capital. Projects’ IRRs are compared to their costs of capital, or
hurdle rates.
Since Projects L and S both have a hurdle rate of 10%, and since both have IRRs greater than
that hurdle rate, both should be accepted if they are independent. However, if they are mutually
exclusive, Project S would be selected, because it has the higher IRR.
4. Would the projects’ IRRs change if the WACC changed?
IRRs are independent of the WACC. Therefore, neither IRRS nor IRRL would change if WACC
changed. However, the acceptability of the projects could change—L would be rejected if
WACC were greater than 18.1%, and S would be rejected if WACC were greater than 23.6%.

e. 1. Draw NPV profiles for Projects L and S. At what discount rate do the profiles cross?

It appears that the crossover rate is between 8% and 9%

2. Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which
project(s)should be accepted if they are independent? Mutually exclusive? Explain. Are your
answers correct at any WACC less than 23.6%?
The NPV profiles show that the IRR and NPV criteria lead to the same accept/reject decision for
any independent project. Consider Project L. It intersects the X-axis at its IRR, 18.1%.
According to the IRR rule, L is acceptable if WACC is less than 18.1%. Also, at any WACC
less than 18.1%, L’s NPV profile will be above the X-axis, so its NPV will be greater than $0.
Thus, for any independent project, NPV and IRR lead to the same accept/reject decision. Now
assume that L and S are mutually exclusive. In this case, a conflict might arise. First, note that
IRRS= 23.6% > 18.1% = IRRL. Therefore, regardless of the size of WACC, Project S would be
ranked higher by the IRR criterion. However, the NPV profiles show that NPVL> NPVS if
WACC is less than the crossover rate. Therefore, for any WACC less than the crossover rate,
say WACC = 7%, the NPV rule says choose L, but the IRR rule says choose S. Thus, if WACC
is less than the crossover rate, a ranking conflict occurs.
f. What is the underlying cause of ranking conflicts between NPV and IRR?

Both NPV and IRR are discounting techniques of capital budgeting which means they are
based on the time value of money factor. NPV indicates the present worth of a project
calculated by deducting the initial cost from the sum of discounted cash flows. IRR on
the other hand is expressed as a percentage and it represents the discount rate that makes
the NPV of a project to be zero.

The conflict between NPV and IRR rankings will mostly be influenced by the status of
the project whether it is an independent project or mutually exclusive. The ranking
conflict has mostly been associated with mutually exclusive projects which are a group of
projects that compete for resources and among the projects an investor can only choose
one. The reasons behind the ranking conflicts are;

Difference in size of investment

IRR will give different results from the NPV if the projects have difference in the size of
investment that is one project requires higher capital than the other.

Projects having unequal useful lives

IRR will give different results from the NPV results if the projects under scrutiny are of
unequal lives and this may mislead the investor in making investment decisions.

Difference in cash flow patterns

When analysing projects with different cash flow patterns, IRR ranking will vary from
the NPV results. Some projects tend to have more cash flows at the initial stages while
others will have lower cashflows and this changes over time.

2. What is the reinvestment rate assumption, and how does it affect the NPV versus IRR
conflict?

The reinvestment rate assumption in the NPV and IRR method results in conflict in the
case of mutually exclusive projects. The discount rate used in the NPV analysis is the
project's opportunity cost of capital and project-specific discount rate. This implies that
future cash flows are reinvested at that discount rate. However, the IRR rate is a discount
rate that equates the sum of the present value of future cash flows with the sum of the
present value of cash outlays. The discount rate in the IRR method is not the project's
opportunity cost of capital, and the rate does not reflect the true riskiness of the
undertaking project. Therefore, the reinvestment rate assumption in the IRR method does
not provide a realistic picture and the NPV method always preferred in this case.

3. Which method is the best? Why?

 Whether NPV or IRR gives better rankings depends on which has the better reinvestment
rate assumption. Normally, the NPV’s assumption is better. The reason is as follows: A
project’s cash inflows are generally used as substitutes for outside capital, that is,
projects’ cash flows replace outside capital and, hence, save the firm the cost of outside
capital. Therefore, in an opportunity cost sense, a project’s cash flows are reinvested at
the cost of capital. Note, however, that NPV and IRR always give the same accept/reject
decisions for independent projects, so IRR can be used just as well as NPV when
independent projects are being evaluated. The NPV versus IRR conflict arises only if
mutually exclusive projects are involved

g. 1. Define the term modified IRR (MIRR). Find the MIRRs for Projects L and S.

The modified internal rate of return (MIRR) assumes that positive cash flows are
reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's
financing cost. By contrast, the traditional internal rate of return (IRR) assumes the cash
flows from a project are reinvested at the IRR itself. The MIRR, therefore, more
accurately reflects the cost and profitability of a project.

2. What are the MIRR’s advantages and disadvantages vis-à-vis the NPV?

MIRR is a better and improved method for project evaluation as it obviates all the
shortcomings of normal IRR and NPV methods. It takes into consideration the practically
possible reinvestment rate. The calculation is also not a rocket science.

The disadvantage of MIRR is that it asks for two additional decisions i.e. determination
of financing rate and cost of capital. These can be estimates again and the managers in
real life may hesitate in involving these two additional estimates.

h. 1. What is the payback period? Find the paybacks for Projects L and S

Payback period is the time in which the initial outlay of an investment is expected to be
recovered through the cash inflows generated by the investment. It is one of the simplest
investment appraisal techniques.

Year Annual Cumulative

0 -100 -100
1 10 -90
2 60 -30
3 80 20
 Project L’s $100 investment has not been recovered at the end of Year 2, but it has been
more than recovered by the end of Year 3. Thus, the recovery period is between 2 and 3
years. If we assume that the cash flows occur evenly over the year, then the investment is
recovered $30/$80 = 0.375 ≈ 0.4 into Year 3. Therefore, Payback L= 2.4 years.
Similarly, Payback S= 1.6 years.

2. What is the rationale for the payback method? According to the payback criterion,
which project(s)should be accepted if the firm’s maximum acceptable payback is 2 years,
if Projects L and S are independent, if Projects L and S
are mutually exclusive?

Payback represents a type of “breakeven” analysis: The payback period tells us when the
project will break even in a cash flow sense. With a required payback of 2 years, Project
S is acceptable, but Project L is not. Whether the two projects are independent or
mutually exclusive makes no difference in this case.

3. What is the difference between the regular and discounted payback methods?

Payback period, or simple payback period, is the period of time required to recoup the
entity's money expended in a particular investment. Discounted payback period, on the
other hand, is t he method of calculating payback period which takes into consideration
the time value of money, that is, all cash inflows will be discounted at a particular
discount rate first to arrive at their present values.

4. What are the two main disadvantages of discounted payback? Is the payback method
of any real usefulness in capital budgeting decisions? Explain

Regular payback has three critical deficiencies: (1) It ignores the time value of money.
(2) It ignores the cash flows that occur after the payback period.(3) Unlike the NPV,
which tells us by how much the project should increase shareholder wealth, and the IRR,
which tells us how much a project yields over the cost of capital, the payback merely tells
us when we get our investment back. Discounted payback does consider the time value of
money, but it still fails to consider cash flows after the payback period and it gives us no
specific decision rule for acceptance; hence, it has 2 basic flaws. In spite of its
deficiency, many firms today still calculate the discounted payback and give some weight
to it when making capital budgeting decisions. However, payback is not generally used
as the primary decision tool. Rather, it is used as a rough measure of a project’s liquidity
and riskiness.

i. As a separate project (Project P), the firm is considering sponsoring a pavilion at the
upcoming World’s Fair. The pavilion would cost $800,000, and it is expected to result in
$5 million of incrementalcash inflows during its 1 year of operation. However, it would
then take another year, and $5 million of costs, to demolish the site and return it to its
original condition. Thus, Project P’s expected net cash flows look like this (in millions of
dollars):

1. What is Project P’s NPV? What is its IRR? Its MIRR?

Year Cash Flow Discounted Rate NPV

0 -800000 (1.10)0 -800000
1 5000000 (1.10)1 4545454.6
2 -500000 (1.10)2 -4132231.4

NPV = -386776.86

We can find the NPV by entering the cash flows into the cash flow register, entering
I/YR = 10, and then pressing the NPV button. However, calculating the IRR presents a
problem. With the cash flows in the register, press the IRR button. An HP-10BII financial
calculator will give the message “error-soln.” This means that Project P has multiple
IRRs. An HP-17BII will ask for a guess. If you guess 10%, the calculator will show IRR
= 25%. If you guess a high number, such as 200%, it will show the second IRR,
400%.1The MIRR of Project P = 5.6%, and is found by calculating the discount rate that
equates the terminal value ($5.5 million) to the present value of costs ($4.93 million).

2. Draw Project P’s NPV profile. Does Project P have normal or non-normal cash
flows? Should this project be accepted? Explain.

You could put the cash flows in your calculator and then enter a series of I/YR
values, get an NPV for each, and then plot the points to construct the NPV profile.
We used a spreadsheet model to automate the process and then to draw the profile.
Note that the profile crosses the X-axis twice, at 25% and at 400%, signifying two
IRRs. Which IRR is correct? In one sense, they both are—both cause the project’s
NPV to equal zero. However, in another sense, both are wrong—neither has any
economic or financial significance. Project P has nonnormal cash flows; that is, it has
more than one change of signs in the cash flows. Without this nonnormal cash flow
pattern, we would not have the multiple IRRs. Since Project P’s NPV is negative, the
project should be rejected, even though both IRRs (25% and 400%) are greater than
the project’s 10% WACC. The MIRR of 5.6% also supports the decision that the
project should be rejected.
Chapter 12
I. ST-1 KEY TERMS: Define the following terms:
a. Incremental cash flow - It is the additional operating cash flow that an organization
receives from taking on a new project. A positive incremental cash flow means that the
company's cash flow will increase with the acceptance of the project. A positive
incremental cash flow is a good indication that an organization should invest in a project.
Sunk Cost - It is a cost that has already been paid for and cannot be recovered in any way
Opportunity Cost – It represents the benefits an individual, investor or business misses
out on when choosing one alternative over another.
Externality – It is an economic term referring to a cost or benefit incurred or received by
a third party.
Cannibalization – It is when acceptance of a new project is expected to decrease cash
flows of an existing project.
b. Stand-Alone Risk - It is the risk associated with a single aspect of a company or a
specific asset.
Corporate (Within Firm) Risk - It is the risk that a project contributes to a company after
taking into consideration the cash flows of the company’s other projects; because projects
are not perfectly correlated, corporate risk usually will be less than stand-alone risk.
Market (beta) Risk – It is the risk that a company contributes to a well diversified
portfolio.
c. Risk-adjusted Costs of Capital - It is the cost of capital appropriate for a given project,
given the riskiness of that project. The greater the risk, the higher the cost of capital.
d. Sensitivity Analysis – It determines how different values of an independent variable
affect a particular dependent variable under a given set of assumptions. This technique is
used within specific boundaries that depend on one or more input variables.
Base-case NPV - It is traditional NPV calculation with one exception - unlevered cost of
equity is used as discount rate (not cost of entire capital). This "base case NPV" says
which value the project brings in excess of this cost of equity. Unlevered cost of equity is
calculated by replacing beta of our company in traditional CAPM with unlevered beta (βu
) of company facing similar business risk operating in the industry where we intend to
diversify
e. Scenario Analysis – It is the process of estimating the expected value of a portfolio after a
given period of time, assuming specific changes in the values of the portfolio's securities
or key factors take place, such as a change in the interest rate. Scenario analysis is
commonly used to estimate changes to a portfolio's value in response to an unfavorable
event and may be used to examine a theoretical worst-case scenario.
Base-Case Scenario – It typically reflects a current (or future) market scenario: your
brand vs. the relevant competition. If there is no relevant competition, or your conjoint
study was designed to model only your product, the base case may be a single product,
reflecting a likely configuration.
Worst-Case Scenario – It is a concept in risk management wherein the planner, in
planning for potential disasters, considers the most severe possible outcome that can
reasonably be projected to occur in a given situation.
Best-Case Scenario - means that it is what people want to happen and are working to
achieve. It is being the best that can possibly be expected.
f. Monte Carlo Situations - are used to model the probability of different outcomes in a
process that cannot easily be predicted due to the intervention of random variables. It is a
technique used to understand the impact of risk and uncertainty in prediction and
forecasting models.
g. Replacement Chain (Common Life) Approach - A method for comparing projects of
unequal lives that assumes that each project can be repeated as many times as necessary
to reach a common life span; the NPVs over this life span are then compared, and the
project with the higher common life NPV is chosen.
Equivalent Annual Annuity (EAA) Method – It is one of two methods used in capital
budgeting to compare mutually exclusive projects with unequal lives. The EAA approach
calculates the constant annual cash flow generated by a project over its lifespan if it was
an annuity. When used to compare projects with unequal lives, an investor should choose
the one with the higher EAA.

III. QUESTIONS
PROBLEM 12-1. Operating cash flows rather than accounting income are listed in Table
12.1. Why do we focus on cash flows as opposed to net income in capital budgeting?

Cash flow is used instead of accounting income because actual cash is required and spent
for the projects or expansion plans of a company. The capital budgeting is a process to
estimate the cash generated and used from a project or new plant. The net income is just a
measure of profitability and doesn't reflect the actual cash that is available for investment.

PROBLEM 12-2. Explain why sunk costs should not be included in a capital budgeting
analysis but opportunity costs and externalities should be included. Give an example of
each.

Sunk costs are expenses that will be incurred regardless. Furthermore, sunk costs are
generally a one time expense that do not continue for the life of the project. Opportunity
cost should be included because they represent cash flows that are being given up in
order to implement the project externalities are impacts that the project has on other
aspects of the company (cannibalization) since this represents a loss in cash flow it
should be considered as well.

Examples:

Sunk Cost - A movie studio spends $50 million on making a movie and an additional $20
million on advertising. But the film disappoints at the box office and grosses just $15
million. Any of that budget that isn't getting recouped is a sunk cost, and the possibility
of it not getting recouped should be factored into other film production budgets even
before it becomes one.

Opportunity Cost - A player attends baseball training to be a better player instead of

taking a vacation. The opportunity cost was the vacation.

Externalities - Air pollution: A factory burns fossil fuels to produce goods. The people
living in the nearby area and the workers of the factory suffer from the deteriorating air
quality.
PROBLEM 12-3. Explain why net operating working capital is included in a capital
budgeting analysis and how it is recovered at the end of a project’s life.

When a firm takes on a new capital budgeting project, it typically must increase its
investment in receivables and inventories, over and above the increase in payables and
accruals, thus increasing its net operating working capital (NOWC). Net working capital
(NWC), is the difference between a company’s current assets, such as cash, accounts
receivable (customers’ unpaid bills) and inventories of raw materials and finished goods,
and its current liabilities, such as accounts payable. Net operating working capital is a
measure of a company's liquidity and refers to the difference between operating current
assets and operating current liabilities. Since this increase must be financed, it is included
as an outflow in Year 0 of the analysis. At the end of the project's life, inventories are
reduced, and receivables are collected. Thus, there is a decrease in net operating working
capital, which represents an inflow in the final year of the project's life.
PROBLEM 12-4. Why are interest charges not deducted when a project’s cash flows for
use in a capital budgeting analysis are calculated?

Capital budgeting is the process a business undertakes to evaluate potential major

projects or investments. The reason is that the interest cost is already considered in the
process of computing the cost of capital. The interest charges are used to compute the
financing cost for debts. Thus, if the interest expenses are deducted, this means its a
double count in the cost of debt financing, resulting in an understatement of the cash
flows.

PROBLEM 12-5 Most firms generate cash inflows every day, not just once at the end of
the year. In capital budgeting, should we recognize this fact by estimating daily project
cash flows and then using them in the analysis? If we do not, are our results biased? If so,
would the NPV be biased up or down? Explain.

Yes, most firms generate cash inflows every day however would be costly to estimate
because we simply cannot forecast accurately at a daily level. In addition, Therefore, it is
usually practice to assume that all cash flows occur at the end of the year. Some projects
also assume that cash flows occur at mid-year, or even quarterly or monthly. It is more
efficiently and accurately to use these frequencies in analyzing cash flow instead of daily
frequency. With regards to NPV, when the project is above (below)
average risk, the NPV methodology is biased upward (downward), because the
methodology assumes that the correct reinvestment rate is the risk adjusted discount
rate.

PROBLEM 12-6 What are some differences in the analysis for a replacement project
versus that for a new expansion project?

Replacement Projects are projects where the firm must either replace worn out equipment
or invest in new equipment that is expected to lower current production costs and/or
increase current sales. While expansion projects are literally any project that works to
expand the reach of a company. In most cases, such projects involve producing new
products or moving into new markets. It may also involve simply increasing the sales of
existing goods and introducing them into new markets. Analysis for replacement projects
usually come in the form of cost savings as compared to expansion projects where cash
flows are arise from the increases in revenues or operating cash flows. Replacement
analysis is concerned with incremental cash flows while expansion projects are
concerned with new cash flows.