Lecture 9 – Integrated Case

Allied Components Company

Chapter 11 (Page 415-416)

A) The process of planning expenditures on long-term projects/assets having cash flows beyond 1
year.

Similarities:

 Mechanics of evaluation (YTM concept discussion)

Differences:

 Firms can control the timing of cash flows in capital budgeting, whereas individual
investors cannot control the same in investment decisions
 Firms/corporate management has to keep eyes open for and create investment
opportunities, whereas individual investors don’t or do it to a much lesser extent

B) Independent projects – cash flows of one project do not affect cash flows of the other project
Mutually exclusive projects – cash flows of one project affect cash flows of the other project

Normal cash flows – sign changes only once (typically negative at start and then all positives)
Non-normal cash flows – sign changes more than once

C)
1. NPV – present value of a project’s cash flows discounted at WACC

Calculation through Excel:

= NPV (WACC, CF from year 1) + initial outflow (which should already be in negative)

NPVL = $18.78

NPVS = $19.98

2. If independent, accept both projects because both have positive NPV and add value to the
firm/shareholder wealth
If mutually exclusive, accept Project S because it has a higher positive NPV

3. Yes, changing WACC changes the NPV because the discount rate changes in the formula.
Inverse relationship between WACC and NPV.

D)
1. IRR – the rate at which NPV = 0

Calculation through Excel:

= IRR (all CF)

 IRRL = 18.13%

IRRS = 23.56%

2. IRR gives the hurdle rate. Value is in % so anyone can easily understand and see if it is more
or less than WACC.

3. If independent, accept both projects because both have IRR > WACC
If mutually exclusive, accept Project S because it has a higher IRR

4. No, changing WACC does not change IRR – this is a weakness of IRR, assumption is that
reinvestment rate is IRR.

E)
1. Draw NPV profiles with WACC 0% to 25% and plot graph

Points of interest:

L – 18% $0.26 (then negative NPV)

S – 23% $0.71 (then negative NPV)

Cross over rate between 9-10% (from graph)

Can be calculated manually as well by equating cash flows of L and S, and then reverse
computing i to get cross over rate

Area on left of cross over rate is conflict; area on right of cross over rate is no conflict

Hence, when we set WACC 5% it was giving conflict. At <9% it will give conflict

2. If independent, accept both projects

If mutually exclusive,
i. At WACC < cross over rate (conflict area), go with higher NPV (trust NPV in conflict)
ii. At WACC > cross over rate (no conflict area), go with higher NPV (as NPV and IRR
would be giving same result in no conflict)

F)
1. Reasons for conflict:
i. Difference in timing of cash flows. For L, majority cash flows are coming later. For S,
they are coming sooner. See where the heavy values are. For L, they are later so
impact of TVM is more.
ii. Project size

Note: If profiles cross over then there is conflict, otherwise no conflict.

2. Assumption is that cash flows can be reinvested at the same IRR.

 3. NPV is best because it gives the dollar value.

Note: If WACC is closer to cross over rate, watch out because can change during life of the
project

G)
1. MIRR – the discount rate at which the present value of project’s cost is equal to present
value of its terminal value.

Can be calculated manually by compounding at WACC rate.

MIRRL = 16.49%
MIRRS = 16.89%

Calculation through Excel:

= MIRR (all CF, blank, WACC)

MIRRL = 16.5%
MIRRS = 16.89%

2. MIRR is better because it takes into account WACC. But does not give dollar value like NPV.

H)
1. Payback period is the amount of time in which firm would recover its initial investment.

L = 2.375 years

S = 1.6 years

2. Payback method tells the riskiness of the project. Longer the time, more risky the cash flows
are.

If independent, accept both projects

If mutually exclusive, accept Project S because lower payback time.

3. Discounted payback takes into account TVM.

4. Disadvantages:
i. Doesn’t give dollar value
ii. Ignores later cash flows after payback period

I)
1. NPVP = - $0.39 million
IRRP = 25%
MIRRP = -3%
2. Draw NPV profiles with WACC at 25% intervals and plot graph

Points of interest:

25% $0.00

400% also $0.00

Thus, double dipping because of non-normal cash flows.