Capital Budgeting Techniques: Workshop 2

Name:
1 Project Analysis
You are a financial analyst for the Hittle Company. The director of capital budgeting has asked you to analyze two proposed
capital investments, Projects X and Y. Each project has a cost of $10,000, and the cost of capital for each is 12%. The
projects’ expected net cash flows are as follows:
a. Calculate each project’s payback period, net present value (NPV), internal rate of return (IRR), modified internal rate of
return (MIRR), and profitability index (PI).
b. Which project or projects should be accepted if they are independent?
c. Which project should be accepted if they are mutually exclusive?
d. How might a change in the cost of capital produce a conflict between the NPV and IRR rankings of these two projects?
Would this conflict exist if r were 5%? (Hint: Plot the NPV profiles.)
e. Why does the conflict exist?

Expected Net Cash Flows

Year Project X Project Y
0 -$ 10,000 -$ 10,000
1 $ 6,500 $ 3,500
2 $ 3,000 $ 3,500
3 $ 3,000 $ 3,500
4 $ 1,000 $ 3,500
Cumulative Cash Flows
0 -$ 10,000 -$ 10,000
1 -$ 3,500 -$ 6,500
2 -$ 500 -$ 3,000
3 $ 2,500 $ 500
4 $ 3,500 $ 4,000
a) payback period 2.17 2.86 years
cost of capital for each is: 12% 12%
net present value (NPV) $ 966.01 $ 630.72
internal rate of return (IRR) 18.03% 14.96%
modified internal rate of return (MIRR) 14.61% 13.73%
profitability index (PI) 1.10 1.06

b) Which project or projects should be accepted if they are independent?

Note that all methods rank Project X over Project Y. Because both projects are acceptable under the NPV, IRR, and MIRR
criteria, both should be accepted if they are independent.

c) Which project should be accepted if they are mutually exclusive?

In this case, we would choose the project with the higher NPV at r = 12%, or Project X.

d) How might a change in the cost of capital produce a conflict between the NPV and IRR rankings of these two projects?
Would this conflict exist if r were 5%? (Hint: Plot the NPV profiles.)
Cost of Capital Project X Project Y
0% $ 3,500
Chart Title $ 4,000 6.2188%
1% $ 3,249 $ 3,657 $ 2,067 $ 2,067
$ 5,000 2% $ 3,007 $ 3,327 $0
3% $ 2,772 $ 3,010
$ 4,000 4% $ 2,545 $ 2,705
5% $ 2,326 $ 2,411
6% $ 2,113 $ 2,128
$ 3,000
7% $ 1,907 $ 1,855
8% $ 1,707 $ 1,592
$ 2,000 9% $ 1,513 $ 1,339
10% $ 1,325 $ 1,095
$ 1,000 11% $ 1,143 $ 859
12% $ 966 $ 631
$0
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

-$ 1,000
 $ 2,000

$ 1,000

13% $ 794 $ 411

$0
0% 1% 2% 3% 4% 5% 6% 7%14% $ 62712% 13% 14%$15%
8% 9% 10% 11% 19816% 17% 18% 19% 20%
15% $ 465 -$ 8
-$ 1,000 16% $ 307 -$ 206
17% $ 154 -$ 399
-$ 2,000 18% $5 -$ 585
19% -$ 140 -$ 765
Project X
20% -$ Project
282 Y -$ 939

e) Why does the conflict exist?

The basic cause of the conflict is differing reinvestment rate assumptions between NPV and IRR: NPV assumes that cash
flows can be reinvested at the cost of capital, whereas IRR assumes that reinvestment yields the (generally) higher IRR. The
high reinvestment rate assumption under IRR makes early cash flows especially valuable, so short-term projects look better
under IRR.

Question 1
A project has an initial cost of $52,125, expected net cash inflows of $12,000 per year for 8 years, and a cost of capital of
12%. What is the project’s NPV, MIRR, PI and PB?.

Cost of capital 12% years Net cash flows

0 -$ 52,125
1 $ 12,000
What is the project’s IRR? 2 $ 12,000
3 $ 12,000
What is the project’s MIRR? 4 $ 12,000
5 $ 12,000
What is the project’s PI? 6 $ 12,000
7 $ 12,000
What is the project’s payback period? 8 $ 12,000

Question 2
Your division is considering two investment projects, each of which requires an upfront expenditure of $15 million. You
estimate that the investments will produce the following net cash flows:
a) What are the two projects’ net present values, assuming the cost of capital is 5%? 10%? 15%?
b) What are the two projects’ IRRs?

Year Project A Project B

0 -$ 15,000,000 -$ 15,000,000
1 $ 5,000,000 $ 20,000,000
2 $ 10,000,000 $ 10,000,000
3 $ 20,000,000 $ 6,000,000
Cost of Capital 5% 5%
Cost of Capital 10% 10%
Cost of Capital 15% 15%
a) NPV at 5%
NPV at 10%
NPV at 15%

b) IRR

Question 3
 Cummings Products is considering two mutually exclusive investments whose expected net cash flows are as follows:

a) What is each project’s IRR? Expected Net Cash Flow

Year Project A Project B
0 -300 -405
1 -387 134
2 -193 134
3 -100 134
4 600 134
5 600 134
6 850 134
7 -180 0
IRR
b) If you were told that each project’s cost of capital was 10%, which project, if either, should be selected? If the cost of
capital were 17%, what would be the proper choice?
Cost of Capital 10% 10%
Cost of Capital 17% 17%
NPV at 10%
NPV at 17%

c) What is each project’s MIRR at the cost of capital of 10%? At 17%? (Hint: Consider Period 7 as the end of Project B’s life.)

Cost of Capital 10% 10%

Cost of Capital 17% 17%
MIRR at 10%
MIRR at 17%

d) Construct NPV profiles for Projects A and B. What is the crossover rate, and what is its significance?
crossover rate 15.00000%
NPN -
Project A Project B
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
21%
22%
23%
24%
25%