Practices Week 4 - 5

The Capital Budgeting

1. A project has an initial outlay of $50,000 and its expected net cash flows are $12,000
per year for the next eight years. The project is to be evaluated using a required rate
of return of 12% p.a.
a. Calculate the project’s NPV
b. Calculate the project’s IRR

2. Petro Ltd is considering three independent projects which are expected to last eight
years each and generate the following net present values and internal rates of return.

Project A Project B Project C

Net Present Value $1,000,000 -$500,000 $1,5000,000
Internal Rate of Return 20.0% 12.0% 22.0%
Project life 8 years 8 years 8 years
The firm uses a discount rate of 14% to evaluate its investment projects. What should
the firm do and why?

3. GLM Ltd is considering three mutually exclusive projects which have the following
net present values and internal rates of return.

Project A Project B Project C

Net Present Value $2,000,000 $2,500,000 $2,9000,000
Internal Rate of Return 20.0% 18.0% 20.0%
Project life 5 years 5 years 5 years
If the firm uses a discount rate of 12% to evaluate its investment projects what should
the firm do and why?

4. Kaimalino Properties (KP) is evaluating six real estate investments. Management

plans to buy the properties today and sell them five years from today. The following
table summarizes the initial outlay and the expected sale price for each property, as
well as the appropriate discount rate based on the risk of each venture. KP has a
total capital budget of $18,000,000 to invest in properties.

a. What is the IRR of each investment?

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 b. What is the NPV of each investment?
c. Given its budget of $18,000,000, which properties should KP choose?
d. Explain why the profitably index method could not be used if KP’s budget were
$12,000,000 instead. Which properties should KP choose in this case?

5. Digem Mines has to choose between two alternative machines A and B which
perform the same function but which have lives of 2 and 4 years, respectively. The
initial cost of machine A is $30,000 and its annual operating costs are expected to be
$6,000. The initial cost of machine B is $42,000 and its annual operating costs are
expected to be $9,000. Assume that the projects are repeatable and there are no
constraints on the availability of funds. Digem will use a discount rate of 10% p.a. to
evaluate the two machines.
a. Compute the net present values of the two machines using the constant chain of
replacement assumption and the lowest common multiple method. Which machine
should Digem choose and why?
b. Redo your analysis in part (a) using the constant chain of replacement assumption
and the perpetuity method. Which machine should Digem choose now? Comment
on any differences between the method used here and that used in part (a).

6. Fitch Industries is in the process of choosing the better of two equal-risk, mutually
exclusive capital expenditure projects, M and N. The relevant cash flows for each
project are shown in the following table. The firm’s cost of capital is 14%.

a. Calculate each project’s payback period.

b. Calculate the net present value (NPV) for each project.
c. Calculate the internal rate of return (IRR) for each project.
d. Summarize the preferences dictated by each measure you calculated, and
indicate which project you would recommend. Explain why.
e. Draw the net present value profiles for these projects on the same set of axes,
and explain the circumstances under which a conflict in rankings might exist.

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