Lahore School of Economics

Financial Management II
The Basics of Capital Budgeting – 2
Assignment 5 Solution

Problems for Assignment

Q1) a. Project A:
CF0 = -6000; CF1-5 = 2000; I = 14.

Solve for NPVA = $866.16. IRRA = 19.86%.

MIRR calculation:
Terminal Value = FV
N = 5; I = 14%; PMT = 2000; FV = $13,220.208

PV of cost = -$6,000

N = 5; PV = -6000; FV = 13220.208; I = MIRRA = 17.12%.

Payback calculation:
0 1 2 3 4 5
| | | | | |
-6,000 2,000 2,000 2,000 2,000 2,000
Cumulative CF: -6,000 -4,000 -2,000 0 2,000 4,000

Regular PaybackA = 3 years.

Discounted payback calculation:

0 14% 1 2 3 4 5
| | | | | |
-6,000 2,000 2,000 2,000 2,000 2,000
Discounted CF: -6,000 1,754.39 1,538.94 1,349.94 1,184.16 1,038.74
Cumulative CF: -6,000 -4,245.61 -2,706.67 -1,356.73-172.57 866.17

Discounted PaybackA = 4 + $172.57/$1,038.74 = 4.17 years.

Project B:
CF0 = -18000; CF1-5 = 5600; I/YR = 14.

Solve for NPVB = $1,225.25. IRRB = 16.80%.

MIRR calculation:
Terminal Value = NFV
N = 5; I = 14%; PMT = 5600; FV = $37,016.583

PV of cost = -$18,000

N = 5; PV = -$18000; FV = $37016.583; PMT = 0; I = MIRR = 15.51%

 Payback calculation:
0 1 2 3 4 5
| | | | | |
-18,000 5,600 5,600 5,600 5,600 5,600
Cumulative CF: -18,000 -12,400 -6,800 -1,200 4,400 10,000

Regular PaybackB = 3 + $1,200/$5,600 = 3.21 years.

Discounted payback calculation:

0 14% 1 2 3 4 5
| | | | | |
-18,000 5,600 5,600 5,600 5,600 5,600
Discounted CF: -18,000 4,912.28 4,309.02 3,779.84 3,315.65 2,908.46
Cumulative CF: -18,000 -13,087.72 -8,778.70 -4,998.86 -1,683.21 1,225.25

Discounted PaybackB = 4 + $1,683.21/$2,908.46 = 4.58 years.

Summary of capital budgeting rules results:

Project A Project B
NPV $866.16 $1,225.25
IRR 19.86% 16.80%
MIRR 17.12% 15.51%
Payback 3.0 years 3.21 years
Discounted payback 4.17 years 4.58 years

b. If the projects are independent, both projects would be accepted since both of their NPVs are positive.

c. If the projects are mutually exclusive then only one project can be accepted, so the project with the
highest positive NPV is chosen. Accept Project B.

Q2) Since the IRR is the discount rate at which the NPV of a project equals zero, the project’s inflows can be
evaluated at the IRR and the present value of these inflows must equal the initial investment.

CF0 = 0; CF1 = 7500; CF2 = 10000; Nj = 10; I = 10.98. NPV = $65,002.11.

Therefore, the initial investment for this project is $65,002.11. Using a calculator, the project's NPV at the
firm’s WACC can now be solved.

CF0 = -65002.11; CF1 = 7500; CF2 = 10000; Nj = 10; I = 9. NPV = $10,239.20.

Q3)
a. Payback A (cash flows in thousands):
Annual
Period Cash Flows Cumulative
0 ($25,000) ($25,000)
1 5,000 (20,000)
2 10,000 (10,000)
3 15,000 5,000
4 20,000 25,000

PaybackA = 2 + $10,000/$15,000 = 2.67 years.

Payback B (cash flows in thousands):

Annual
Period Cash Flows Cumulative
0 ($25,000) ($25,000)
1 20,000 (5,000)
2 10,000 5,000
3 8,000 13,000
4 6,000 19,000

PaybackB = 1 + $5,000/$10,000 = 1.50 years.

b. Discounted Payback A (cash flows in thousands):

Annual Discounted @10%
Period Cash Flows Cash Flows Cumulative
0 ($25,000) ($25,000.00) ($25,000.00)
1 5,000 4,545.45 (20,454.55)
2 10,000 8,264.46 (12,190.09)
3 15,000 11,269.72 (920.37)
4 20,000 13,660.27 12,739.90

Discounted PaybackA = 3 + $920.37/$13,660.27 = 3.07 years.

Discounted Payback B (cash flows in thousands):

Annual Discounted @10%
Period Cash Flows Cash Flows Cumulative
0 ($25,000) ($25,000.00) ($25,000.00)
1 20,000 18,181.82 (6,818.18)
2 10,000 8,264.46 1,446.28
3 8,000 6,010.52 7,456.80
4 6,000 4,098.08 11,554.88

Discounted PaybackB = 1 + $6,818.18/$8,264.46 = 1.825 years.

c. NPVA = $12,739,908; IRRA = 27.27%.

NPVB = $11,554,880; IRRB = 36.15%.

Both projects have positive NPVs, so both projects should be undertaken.

 d. At a discount rate of 5%, NPVA = $18,243,813.
At a discount rate of 5%, NPVB = $14,964,829.

At a discount rate of 5%, Project A has the higher NPV; consequently, it should be accepted.

e. At a discount rate of 15%, NPVA = $8,207,071.

At a discount rate of 15%, NPVB = $8,643,390.

At a discount rate of 15%, Project B has the higher NPV; consequently, it should be accepted.

f. ∆CF =
Year CFA – CFB
0 $ 0
1 (15)
2 0
3 7
4 14

IRR∆ = Crossover rate = 13.5254% ≈ 13.53%.

g. MIRRA:
Terminal Value = NFV
CF0 = 0; CF1 = 5000; CF2 = 10000; CF3 = 15000; CF4 = 20000; I = 10%, NFV = $55,255

PV of cost = -$25,000

N = 4; PV = -$25000; FV = $55,255; PMT = 0; I = MIRR = 21.93%

MIRRB:
Terminal Value = NFV
CF0 = 0; CF1 = 20000; CF2 = 10000; CF3 = 8000; CF4 = 6000; I = 10%, NFV = $53,520

PV of cost = -$25,000

N = 4; PV = -$25000; FV = $53,520; PMT = 0; I = MIRR = 20.96%

According to the MIRR approach, if the 2 projects were mutually exclusive, Project A would be
chosen because it has the higher MIRR. This is consistent with the NPV approach.

Examples
Q1) a. Project X: CF0 = -10,000, CF1 = 6,500, CF2 = 3,000, CF3 = 3,000, CF4 = 1,000,
NPV = $966.012. IRR = 18.03%

Project Y: CF0 = -10,000, CF1 = 3,500, CF2 = 3,500, CF3 = 3,500, CF4 = 3,500,
NPV = $630.72. IRR = 14.96%

MIRR:
Project X:
Terminal Value = NFV
CF0 = 0, CF1 = 6,500, CF2 = 3,000, CF3 = 3,000, CF4 = 1,000, NFV = $17,255.232

PV = -$10,000, FV = $17,255.232, N = 4, I = MIRR = 14.61%

Project Y:
Terminal Value = NFV
 CF0 = 0, CF1 = 3,500, CF2 = 3,500, CF3 = 3,500, CF4 = 3,500, NFV = $16,727.648

PV = -$10,000, FV = $16,727.648, N = 4, I = MIRR = 13.73%

Payback Period:

Project X: Payback = 2 + 500/3000 = 2.17 years.

Project Y: Payback = 2 + 3000/3500 = 2.86 years.

Discounted Payback Period:

Project X:

DPP = 2 + 1804.85/2135.34 = 2.84 years.

Project Y:

DPP = 3 + 1593.59/2224.31 = 3.72years.

b. All methods rank Project X over Project Y. In addition, both projects are acceptable under the NPV, IRR, and
MIRR criteria. Thus, both projects should be accepted if they are independent.

c. When the projects are mutually exclusive, we would choose the project with the higher NPV i.e. Project X.

d. Calculating incremental cash flows: CF0 = 0, CF1 = 3000, CF2 = -500, CF3 = -500, CF4 = -2500,
Crossover rate = IRR of incremental cash flows = 6.21%

Q2) The IRR is the discount rate at which the NPV of a project equals zero. Since we know the project’s initial
investment, its IRR, the length of time that the cash flows occur, and that each cash flow is the same, then we can
determine the project’s cash flows by setting it up as a 10-year annuity.
N = 10, I = 12, PV = -1000, PMT = $176.98.

Project’s MIRR:
Terminal Value = FV of inflows:
N = 10, I = 10, PV = 0, and PMT = -176.98. FV = $2,820.61.
N = 10, PV = -1000, PMT = 0, and FV = 2820.61, I = MIRR = 10.93%.