Exercise 2A FINA2010 SP 2024 Capital Budgeting

1. Viet Company plans to choose from the following mutually exclusive projects.
Project A: Cost $59 million, Project life two years, Annual cash inflow: $35
million.
Project B: Cost $6 million, Project life three years, Annual cash inflow: $3.2
million.
The cost of capital for both projects is the same, at 10%, and the projects can be
repeated, divided, and duplicated. Which project should the company choose?

Projects A and B have different lives. We need to make them have the same 6-year
lives by repeating three times for A and two times for B. The CFs for these projects
are:

A: |_____|_____|_____|_____|_____|_____|
-59 35 35 35 35 35 35
-59 -59

B: |_____|_____|_____|_____|_____|_____|
-6 3.2 3.2 3.2 3.2 3.2 3.2
-6

NPVA = 35/1.1 – 24/1.12 + 35/1.13 - 24/1.14 +35/1.15 + 35/1.16 -59 = 4.376

NPVB = 3.2/1.1 + 3.2/1.12 – 2.8/1.13 + 3.2/1.14 +3.2/1.15 + 3.2/1.16 – 6 = 3.429

Therefore, Project A was chosen.

2. A firm is evaluating the following two projects using the NPV method: Project A
costs $10 million and generates positive cash flows of $5 million in the first year
and $8 million in the second year; Project B costs $2 million and generates $1
million in the first and $2 million in the second year. The cost of capital is 10%. If
these projects are independent, what project(s) should be chosen? If these are
mutually exclusive, then what should be selected?
If two projects can be combined and invested as one project, what will be the NPV
of this combined project? Explain the meaning of this result compared to the
answers to previous questions.

NPVA = 5/1.1 + 8/1.12 – 10 = 1.157

NPVB = 1/1.1 + 2/1.12 – 2 = 0.562

If they are independent, then choose both.

If they are mutually exclusive, then choose A.

If they are combined, then the CFs are,

|_____|_____|
 -12 6 10

The NPV is 1.719 million, which is the same as 1.157 + 0.562.

This means that the NPV method meets the “Value Additive” principle.

3. A firm is considering the following five projects:

Proj PV of COF PI
1 200 K 1.4
2 400 1.1
3 400 1.35
4 800 1.05
5 600 1.3

The total investment capital is limited to $1.2 million. Project 1 is subordinated to

Project 2 (whenever Project 2 is taken, project 1 should also be taken), and Projects
3 and 5 are mutually exclusive. All projects are not divisible. What is the optimum
combination for the firm to invest in?

The NPVs for these projects are:

Project 1: 200 x 1.4 – 200 = 80

Project 2: 400 x 1.1 – 400 = 40
Project 3: 400 x 1.35 – 400 = 140
Project 4: 800 x 1.05 – 800 = 40
Project 5: 600 x 1.3 – 600 = 180

All possible combinations of the projects within the limited capital of 1.2 million
are:
(1), (3), (4), (5), (1,2), (1,4), (1,5), (1,2,3), (1,2,5), and (3,4)

The best combination is (1,2,5), and the NPV is 300K.