Professional Documents
Culture Documents
Submitted to:
Prof. Dr. Radhe S. Pradhan, Ph.D.
Ace Institute of Management
New Baneshwor
Submitted by:
Sachindra Pradhanga
Sagar Nath Upadhyaya
Serish Dhital
Sudeep Bir Tuladhar
Sushil Bajimaya
Chandika Amgain
EMBA, Fall 2011
Contents
Background ..................................................................................................................................... 1
Projects ........................................................................................................................................ 1
Project A: Major Plant Expansion .......................................................................................... 1
Project B: Alternative Plan for Plant Expansion..................................................................... 1
Project C: Purchase of New Press ........................................................................................... 2
Project D: Upgrade of Egrets Video Text Service ................................................................ 2
Question 1 ....................................................................................................................................... 3
Payback, NPV, IRR Determination ........................................................................................ 3
Project Ranking ....................................................................................................................... 3
Project Selection ..................................................................................................................... 4
Appropriate Discount Rate ..................................................................................................... 4
Question 2 ....................................................................................................................................... 7
Calculation of Equivalent Annual Annuity (EAA) for each project....................................... 8
Question 3 ..................................................................................................................................... 10
Question 4 ..................................................................................................................................... 13
Question 5 ..................................................................................................................................... 20
Question 6 ..................................................................................................................................... 22
Question 7 ..................................................................................................................................... 24
Question 8 ..................................................................................................................................... 27
Question 9 ..................................................................................................................................... 29
Question 10 ................................................................................................................................... 31
Annex ............................................................................................................................................ 32
Calculation of Payback Period .................................................................................................. 32
Project A ............................................................................................................................... 32
Project B................................................................................................................................ 32
Project C................................................................................................................................ 32
Project D ............................................................................................................................... 33
Discounted Payback Period for Project A ............................................................................ 33
Project B................................................................................................................................ 34
Project D ............................................................................................................................... 35
Net Present Value ..................................................................................................................... 36
IRR (Internal Rate of Return) ................................................................................................... 36
Project B................................................................................................................................ 36
Project C................................................................................................................................ 37
Project D ............................................................................................................................... 37
Background
Egret Printing and Publishing Company is a family owned speciality printing business founded
by John and Keith Belford in 1956 after they were retired from the US Army. Patrick Hill, Keith
Belfords son in law, joined the firm in 1979 in the Accounting Department and was promoted as
a treasurer in 1988 and then as the Vice-President of Finance in 1994. Hill has the responsibility
for both external and internal financial operations, but mostly it is internal. John and Keith
Belford were reluctant about long term debt financing their business because they were aware of
the difficulties their father faced during the Great Depression. However, Hill doesnt agree with
this philosophy and feels that all equity capital structure is conservative.
The term capital budgeting refers to the process of decision making by which firms evaluate the
purchase of major fixed assets, including building, machineries, and equipment. Capital
budgeting describes the firms formal planning process for the acquisition and investment of
capital and results in capital budget that is the firms formal plan for the expenditure of money to
purchase new fixed asset for expansion or replacement of business.
Hill is presently occupied with detailed analysis of four major capital investment proposals that
the Belfords have identified as possible candidates for funding in the coming year. A description
of each of the four projects is also given that includes information such as the costs and expected
after-tax cash flows (net income plus depreciation). The four projects are considered to be
equally risky and their risk is about the same as that of the companys other assets.
Projects
Project A: Major Plant Expansion
This project is designed to alleviate the capacity problem by constructing a new wing on the
main plant. This additional space would allow to hold a greater variety of paper stock in
inventory and to reposition its various processes for a more efficient work flow.
Project B: Alternative Plan for Plant Expansion
This project is an alternative of project A. It can be installed much more quickly and will allow
Egret to take several major printing jobs in the next few years.
Question 1
Determine the Payback, net present value and the internal rate of return for each project,
using both 15 and 21 percent discount rates; rank the investment proposals considering the
capital budget of $ 1.5 million. Which projects should the company choose and why? (Note:
Projects A and B are mutually exclusive).
Payback, NPV, IRR Determination
Payback period, Net Present Value and Internal rate of return for all four projects are as follows:
Projects
PP
DPP@15%
DPP@21%
NPV@15%($) NPV@21%($)
IRR
3.148675
3.530375
3.755012
166,167.40
70,720.60
26.62227
1.481481
1.857931
2.1122
159,447.70
100,534.00
34.99251
3.0959
1.881595
2.068357
625,400.60
309,409.7
29.94826
2.8571
3.980313
4.678977
141,480.00
12,032.50
22.10892
Project Ranking
Rank
NPV@15%
All cash flows are discounted at the appropriate market-determined opportunity cost of
capital.
NPV of a project is exactly the same as the increase in shareholders wealth as can be
seen from below:
Project Selection
Project Combination Required Investment NPV@15% Rank NPV@ 21% Rank
A and C
1,500,000
$791,568.00
$380,130.3
B and C
1,500,000
$784.848.3
$409,943.7
C and D
1,500,000
$766.880.6
$321,442.2
A and D
1,000,000
$307.647.4
$82,753.1
B and D
1,000,000
$300.927.7
$112,566.5
If the discount rate is 15%, then the company should choose the combination of projects A and
C. If the discount rate is 21%, then company should choose the combination of projects B and C.
The NPV of combination give highest value compared to others. The combination C and D is not
feasible because project C cannot be implemented if both projects A and B are rejected.
Appropriate Discount Rate
Since the net present value at 15% discount rate is higher than that of 21%, 15% is more
appropriate percentage for discounting.
Comparison of Different Projects
Payback period, discounted payback period, net present values and internal rates of return for all
of the projects are compared with each other in the following graphs.
40
35
30
25
Project A
Project B
20
Project C
15
Project D
10
5
0
IRR
Question 2
Do you find anything wrong in choosing the projects based on payback, NPV and IRR as
stated above? What suggestions can be made to the company? How should the projects
with unequal lives be dealt with? Determine the equivalent annual annuity (EAA) for each
project and based on the calculations, which projects should Egret Printing and Publishing
Company accept for the coming year and why?
Payback Period is the number of years required to recover the initial capital expenditure on a
project. Payback period is also the ratio of Original Investment to Annual cash flow having
condition, if cash are equal or even. Since payback period is easy to calculate it is being widely
used. But it has some limitations like: It does not consider time value of money; it is not capable
to measure profitability, Ignores cash flows occurring after the payback period. Due to some of
these limitations the firm cannot fully rely on this method only for choosing among the projects.
Net Present Value (NPV) requires finding the present value of the expected net cash flows of an
investment, discounted at the cost of capital, and subtracting from it the initial cost outlay of the
project. NPV is considered feasible only if the firm knows the cost of capital or discounted
factor, which may not be the current cost existing in the market. NPV is a useful starting point to
value investments, but certainly not a definitive answer that an investor can rely on for all
investment decisions.
Internal Rate of Return (IRR) is the interest rate that equates the present value of the expected
future cash flows, or receipts, to the initial cost outlay. If IRR is greater than cost of capital we
accept the project else we reject it. The main drawback of IRR is, it is difficult to understand as
there may be two experimental rates because of unequal present value of cash inflow with
present value of cash outflow; it is not helpful for comparing two mutually exclusive investments
and comparing two projects.
Project choice based on Payback, NPV and IRR are not always consistent. They may give
different indications about the projects financial characteristics. Moreover the decision on
different age of projects cant be sufficed by calculating NPV without taking consideration of
project life. The reason for this potential problem is the timing of the cash flows of the mutually
exclusive projects. As a result, there is a need to adjust for the timing issue in order to correct
this problem.
Project with unequal lives can be dealt with two methods they are:
1. Replacement-chain method: In this approach the projects under the evaluation are made
by making the lives of the project common or equal lives.
2. Equivalent annual annuity: in this approach the constant annual annuity is calculated for
the projects that has the same NPV as that calculated in the projects.
The company can be suggested to calculate the Equivalent Annual Annuity (EAA) by
eliminating the effect of the life of the project. EAA will give the average annual return that each
project will provide. So comparing the same annual return is realistic. The project having the
highest EAA should be chosen as higher EAA is associated with higher NPV. But we should
equally take care on whether the given annual return can be replicated by short life projects in
the same way.
Calculation of Equivalent Annual Annuity (EAA) for each project
Project
Years
NPV@15%
NPV @ 21%
PMT=
NPV/PVIFA15%,
4years
PMT=
NPV/PVIFA21%, 4years
164,577.60
57,645.39
71,043.60
27,969.92
156,038.00
54,654.29
100,488.00
39,562.20
10
621,137.00
122,006.87
310,088.00
76,489.39
86,775.00
25,887.53
2,225.00
4,178.06
Particulars
EAA @15%
EAA @21%
Project A
57645.39
27969.92
Project B
54654.29
39562.2
Project C
122006.87
76489.39
Project D
25887.53
4178.06
Project
EAA @ 15%
Rank
EAA at 21%
Rank
Combination
A and C
$179,652.26
1
$104,459.31
2
B and C
$176,661.16
2
$116,051.59
1
C and D
$147,894.40
3
$80,667.45
3
A and D
$83,532.92
4
$32,147.98
5
B and D
$80,541.82
5
$43,740.26
4
Hence from the above calculation we can conclude that: at 15% A and Cs combination is the
best and at 21% B and Cs combination is the best as both combination has highest EAA
achieved.
Question 3
Draw the graph of NPV versus discount rate for projects A and B (a present value profile)
using, in part, your answers for the IRR and NPV in Question 1. Also determine the
crossover rate by following the computational procedure. Which Project appears to be
superior? Why?
Calculation for the Graph
Project A
Project
A
-500,000
136,000
136,000
136,000
618,800
PVIF
@0%
1
1
1
1
1
PV
@ 0%
-500,000
136,000
136,000
136,000
618,800
526,800
PVIF
@
10%
1
0.909
0.826
0.751
0.683
PV
@ 10%
-500,000
123,624
112,336
102,136
422,640.4
260,736.4
PVIF
@
20%
1
0.833
0.694
0.579
0.482
PV
@ 20%
-500,000
113,288
94,384
78,744
298,261.6
84677.6
PVIF
@ 30%
1
0.769
0.592
0.455
0.35
PV
@30%
-500,000
104,584
80,512
61,880
216,580
-36,444
PVIF
@
40%
1
0.714
0.51
0.364
0.26
PV @
40%
-500,000
97,104
69,360
49,504
160,888
-123,144
Project B
PVIF
PV @
@
0%
10%
-500,000
1
370,000 0.909
270,000 0.826
155,000 0.751
49,000 0.683
344,000
Calculation of Crossover rate
Project PVIF
B
@0%
-500,000
1
370,000
1
270,000
1
155,000
1
49,000
1
Year
0
1
project A
(CF)
-500000
136000
136000
PV @
10%
-500,000
336,330
223,020
116,405
33,467
209,222
Project B
Diff.(CF
(CF)
)
-500000
0
370000
234000
270000
-134000
PVIF
@
20%
1
0.833
0.694
0.579
0.482
PV @
20%
-500,000
308,210
187,380
89,745
23,618
108,953
PVIF
PVIF
@
PV
@
30% @30% 40%
1 -500,000
1
0.769 284,530 0.714
0.592 159,840 0.51
0.455
70,525 0.364
0.35
17,150 0.26
32,045
PVIF@16
%
1
-0.862
PV
0
-201708
PVIF@17
%
1
0.8547
0.7431
-99575.4
0.7305
PV @
40%
-500,000
264,180
137,700
56,420
12,740
-28,960
PV
0
199999.8
-97887
3
4
136000
618800
155000
49000
-19000
569800
0.6407
0.5523
-12173.3
314700.5
4
1243.84
0.6243
0.5336
-11861.7
304045.2
8
-5703.22
The crossover chart shows the crossover rate is 16.17 %. It means both the project have same
NPV i.e. 144320 at this rate. Strictly from quantitative view, below the crossover rate, Project A
is better whereas above the crossover rate, Project B is better in terms of NPV. The relative
stability of NPV of project B over project A may be added factor that will provide us qualitative
reason to choose project B at some rate below crossover rate. Not only this, Project B is
relatively stable. It is because the significant portion of cash inflow of project B occurs at the
beginning years whereas the highest cash flow of project A occurs at the end of year 4. Therefore
the fluctuation on WACC will also have less impact on the Project B whereas project A is highly
sensitive. IRR also supports project B but IRR is not a sole determinant in the decision to select
project B and it is NPV that matters most.
In this case, Project B is our obvious choice because the required rate is 21 % which is above
crossover rate where NPV is higher for project B than project A. The conflict only arises in
choosing project if the required rate drops below crossover rate. In that case we may choose
project A if there is certainty that the required rate will not cross the crossover rate significantly
during the project life. Otherwise project B is best.
Question 4
Now suppose that Hill made a mistake in the projected cash flows for Project D they
should have been $195,000 per year. Determine the effect of this change would have on
capital budgeting. Would this situation bear on the decision about the mutually exclusive
projects? Explain.
Project D
After correction in Cash Flows
a) Ordinary Payback Period
Original Investment
Year 1
Year 2
Year 3
Year 4
Year 5
Cash Flows
Cumulative Cash Flows
-500,000
-500,000
195,000
-305,000
195,000
-110,000
195,000
85,000
195,000
200,000
195,000
375,000
153,835
Year
0
1
2
3
4
5
c) IRR
Year
0
1
2
3
4
5
Year
0
1
2
3
4
5
CFs
PVIF @ 27% PV
Cumulative CFs
-500,000
1 -500,000
-500,000
195,000
0.787
153,465
-346,535
195,000
0.62
120,900
-225,635
195,000
0.488
95,160
-130,475
195,000
0.384
74,880
-55,595
195,000
0.303
59,085
3,490
NPV
3,490
CFs
PVIF @ 28% PV
Cumulative CFs
-500,000
1 -500,000
-500,000
195,000
0.781
152,295
-347,705
195,000
0.61
118,950
-228,755
195,000
0.477
93,015
-135,740
195,000
0.373
72,735
-63,005
195,000
0.291
56,745
-6,260
NPV
-6,260
IRR = Lower Rate + {NPV of LR / (NPV of LR - NPV of HR)}* (HRLR)
= 27% + {3,490/ (3,490+6260)}* (28-27)
= 27% + 0.36
= 27.36
Criterion
Ordinary
Payback
period
NPV @ 15 %
NPV @ 21%
IRR
Discounted
payback period
@ 15%
Discounted
payback period
@ 21%
Project D (cash
flow of Rs.175,000
each year)
Changes
2.86
86,775
12,225
22.11
2.56
153,835
70,765
27.36
0.3
-67,060.00
-58,540.00
-5.25
4.02
3.48
0.54
Result
Decrease in
payback period
Increase in NPV
Increase in IRR
Decrease in
discounted payback
4.82
4.05
0.77
Project A
Project B
Project C
Project D
-500,000.00
-500000 -1,000,000.00 -500,000.00
136,000.00
370000
323,000.00
195,000.00
136,000.00
270000
323,000.00
195,000.00
136,000.00
155000
323,000.00
195,000.00
618,800.00
49000
323,000.00
195,000.00
323,000.00
195,000.00
323,000.00
323,000.00
323,000.00
323,000.00
323,000.00
$164,577.60
$156,038
$621,137
$153,835
$71,043.60
$100,488
$310,088
$70,765
26.61%
35.02%
29.94%
27.36%
3.15 years
1.48 years
3.1 years
2.56 years
Discounted payback
period @ 15%
3.54 years
1.87 years
4.48 years
3.48 years
Discounted payback
period @ 21%
3.75 years
2.11 years
5.53 years
4.05 years
the annual cash flow changed from $175,000 to $195,000 when the discount rate is 15%. When
the discount rate is 21%, the NPV of this project increased from $12,050 to $70,570. Similarly,
the IRR of the project has also increased from 22.16% to 27.46%. With the changed cash flow of
Project D, the payback periods at both discounting rates of 15% and 21% have also decreased
slightly.
The calculation of NPV, IRR and payback periods all imply that Project D is feasible. However,
due to the constraints of the capital budget, the selection of Project D cannot be considered since
Project A and Project C has been recommended which adds up to the available budget of $1.5
million. In order to select Project D, the company would have to acquire a long-term debt of
$500,000. The new debt of $500,000 for Project D, however, would not make any difference to
the mutually exclusive projects.
30.00
25.00
20.00
15.00
10.00
5.00
Payback
IRR
Discounted
Discounted
payback period payback period
@ 15%
@ 21%
Comparison of Payback Period (years), IRR (%) and Discounted payback period at different
rates of Project D, after changes in Cash Flows
180,000
160,000
140,000
120,000
100,000
80,000
60,000
40,000
20,000
NPV @ 15 %
NPV @ 21%
Project B
Project C
300000
200000
100000
0
NPV @ 15%
NPV @ 21%
Comparison of NPV at different rates of all the projects, before and after changes in Cash Flows
of Project D
40
35
30
Project A
25
Project B
20
Project C
15
10
5
0
IRR
Comparison of IRR of all the projects, before and after changes in Cash Flows of Project D
Project A
Project B
Project C
Project D (Rs. 195,000)
Discounted payback
period @ 15%
Discounted payback
period @ 21%
Comparison of Payback period and discounted payback period at different rates of all the
projects, before and after changes in Cash Flows of Project D
Question 5
Assuming that the return on Project A is representative of the investment opportunitities
generally found on the printing industry, would it be reasonable for Hill to claim that
project B will generate a return of approximately 35 percent over its four year life?
Explain in terms of available reinvestment rates.
We Know that the Internal Rate of Return (IRR) is the discounting factor that makes the NPV of
the project zero. In this case the IRR of project A is approximately 27%. Since project As IRR is
equal to reinvestment rate, reinvestment rate would be 27% as well. Similarly, the IRR of project
B is 35%. Hence the representative of investment opportunities for printing industry is only 27%
which is much lower than 35% it would not be reasonable to claim that Project B will generate a
return of approximately 35% over four year life.
Calculation of MIRR:
For Project B
Year
1
2
3
4
Cash Inflows
FVIF @ 27%
$370,000.00
2.0483
$270,000.00
1.6129
$155,000.00
1.27
$49,000.00
1
Terminal Value of Cash Inflows
FV of Inflows
$757,871.00
$435,483.00
$196,850.00
$49,000.00
$1,439,204.00
MIRR is calculated to determine the rate at which the present value of a projects outflow equals
the terminal value of the projects inflows. Trying at 35% and 25%, we get
PVIF
35%
Present Value of
Terminal Cash Inflow
Present Value of
Outflow
NPV
@ PV @ 35%
$1,439,204
0.3011
$433,344.32
$500,000
$500,000
($66,655.68)
PVIF @ 25%
PV@ 25%
0.4096 $589,497.96
1
$500,000
$89,497.96
= 30.73%
As we can see in the above calculation, MIRR of the project B is 30.73% at reinvestment rate of
around 27%. Therefore, it can be concluded that for reinvestment of around 27%, project B will
generate return around 30.73%
Question 6
If Hill is confident that he will be a ble to generate more and better projects in the years to
come, but relatively doubtful that he will be able to persuade the Belford brothers to
employ debt financing, how might this influence his recommendation. Could there ever be
a situaltion in which project D is advisable? Explain.
Egret Printing and Publishing Company has stuck to an extremely conservative approach of
capital structure by adapting all equity capital. The cost of equity capital is 15% for the capital
budget of $1.5 million. The company is reluctant to modify its financing style due to some bad
experience in the past. But the company should be open to change if the facts and figures are in
favour. So if debt financing generates higher returns then the company should be open to it as
well.
Patrick Hill has done his homework. He has discussed with the bank about debt financing and
has got an assurance of $500,000 at the rate of 12%. From the discussions with Belfords, Hill has
come to a conclusion that their opportunity cost on outside investments is 21%. Funds over and
above the $1.5million that will be generated internally are available, but the marginal cost of this
extra capital is 21% rather than 15% cost of internal funds. Though Belford brothers have
resisted the attempts to convince them to use debt, they are always willing to listen to new
arguments on the subject.
If Belford Brothers are convinced to opt for a debt financing of $500,000 then the total capital of
the company will increase from $1.5million to $2million.
Then the new capital structure will be:
Type of capital
Long term debt
Preferred stock
Common equity
Amount ($)
500,000
0
1,500,000
Calculation of kdt:
Interest rate of debt (kd)
= 12%
Weight
0.25
6.48%
0
0
0.75
15%
Weighted average cost of capital
Weighted
Cost
1.62%
0
11.25%
12.87%
This shows that the weighted average cost of capital has decreased from 15% to 12.87%. Also
the increase in capital will allow the company to undertake an additional project. Projects A and
Project B are purposed as alternatives and we have recommended one of them so the next option
is project D with a total investment of $500,000. So project D is advisable in this scenario.
Question 7
If the Belfords agree to Hills proposal to use a modest amount of debt to finance the
projects this year, what would be its implication on the present capital structure and the
cost of capital? In terms of the future returns to the Belfords families, what would be the
impactfrom using this debt financing or what would be the extra value addition in the
present values of the selected projects? (Revise your computations using a new discount
rate and conclude about the projects to be chosen.)
If Belfords agree to Hills proposal to use debt financing, they will use $500,000 debt at 12%
interest rate. So, the company has now, $ 2 million to invest in the projects and can choose three
projects. From the investment of 2,000,000 we can select three projects, we can choose either (A,
C & D) or (B, C & D) since Project A and Project B are presented as alternatives in the case.
Calculation of the new cost of capital with their respective financial source weights is already
shown in the previous section. This gave the weighted average cost of capital to be 12.87%.
Now,
PVIF
@12.87
-500,000
Cash
Flow(B)
500,000
0.886
136,000
0.785
Yr.
0
Cash
Flow(A)
Cash
Flow(C)
Cash
Flow(D)
PV(A)
PV(B)
PV(C)
PV(D)
-1,000,000
-500,000
-500,000
-500,000
-1,000,000
-500,000
370,000
323,000
175,000
120,496
327,810.756
286,169.93
155,045.628
136,000
270,000
323,000
175,000
106,760
211,936.967
253,539.408
137,366.552
0.695
136,000
155,000
323,000
175,000
945,74.4
107,794.381
224,629.581
121,703.333
0.616
618,800
49,000
323,000
175,000
381,242.68
301,91.3116
199,016.197
107,826.113
0.546
323,000
175,000
176,323.378
955,31.2419
0.484
323,000
156,218.107
0.428
323,000
138,405.34
0.38
323,000
122,623.673
0.336
323,000
108,641.511
10
0.298
323,000
96,253.6643
TPV of Inflows
703,073.08
677,733.415
1,761,820
617,472.868
NPV
203,073.08
177,733.415
761,820.79
117,472.868
Initial
Investment
2 million
2 million
NPV
1,082,366.74
1,057,027.07
PV of Inflow
3,082,366.74
3,057,027.07
Profitability
Index(PI)
1.54
1.52
From this table we can select projects A, C and D when the company takes the debt financing
with 12.87% cost of capital. When 15% cost of capital was taken as discounting factor, the
combined NPV of project A& C reveals higher value. So, this was selected as the best
combination. Also, there was internal financing through retained earnings and excluded external
financing through debt.
With all Equity financing at 15% cost of Capital:
Net present value of project A & C = NPV of Projects (A + C)
= $(166,167.40+625,400.60)
=$791,568.00
The impact of using this debt financing is shown by the extra value addition in present values of
selected project:
Particulars
Net present value of selected projects after inclusion of debt in capital structure
Less: Net present value of selected projects before inclusion of debt in capital
structure.
Extra value additional due to use of debt financing
Amount
$1,082,366.74
$791,568
$290,798.74
This shows that when debt financing is used the company can yield more NPV as debt financing
helps to leverage the capital structure. Debt financing is relatively cheaper financing method as
the company can utilize capital with lower rate. Therefore, instead of using the combination of
projects A & C, the combination of A, C & D should be selected considering the profitability
index which is calculated on the basis of NPV and Total PV of inflows.
Question 8
Assuming that the $1.5 million of internal funds available to finance new investment is
after paying a dividend of $300,000 and represents an average addition to retained
earnings, do you consider the use of $500,000 of debt to increase the risk to the Belfords by
very much? Explain by considering times interest earned ratio.
Amount
300,000
1,500,000
1,800,000
Calculation of EBIT:
Particulars
EBIT
Less: Interest
EBT
Less: Tax @ 46%
Net Profit
Amount
3,393,333.33
60,000
3,333,333.33
1,533,333.33
1,800,000
Thus it is seen that the internal funds of $1.5 million after paying a dividend of $300,000 will
yield interest earned ration of 56.55 with use of $500,000 of debt. This represents a very healthy
ratio. The reason behind this high interest earned ratio is low amount of debt capital used by the
company and only a small portion of EBIT will be required to pay the interest expense. Hence it
is clear that the use of $500,000 of debt will not increase the risk to the Belfords very much.
Question 9
The case stated that Project C would be feasible unless either Project A or Project B was
also accepted. What is the implication of this statement on the current capital budgeting
analysis? Do you think that the way Project C is handled earlier in the case valid? Why or
why not?
As mentioned in the case, projects A and B are mutually exclusive so that either of this project
can be chosen at one particular time whereas project C cannot be feasible unless projects A or B
is accepted. Basically projects A and B are related to alleviating capacity problem by expansion
of the plant where as project C is related to purchase of new printing equipment and press. Once
the new equipment and press is bought, it will require additional space to function. So project A
and B provides the basis required for project C to be implemented. Therefore the feasibility of
project C is very much dependent on acceptance of either project A or project B.
Moreover, project C does not have any side effect on viability and profitability of project A and
project B. Hence, project A and B are independent upon C whereas project C is dependent on
either of them.
Another implication is that a project combination of C and D could never be used. Although a
project combination of C and D requires $1,500,000, however, for C to be implemented, further
$500,000 needs to be invested in either Project A or B. This would take the total investment to
$2 million which requires debt and the firm is not in a position to use the debt capital.
The way project C is handled is not very logical we already know that project C is dependent on
acceptance of project A or B. It will be very convenient and logical if we can take dependent
projects as a single alternative and deal as a joint project like projects A & C and projects B& C
should have been treated as single projects. Hence the number of options to rank should have
been 5 and they are: project A, project B, project A&C, project B&C and project D. The cash
flow and project outlay of the joint projects also should have been combined. Due to its
dependency, project C has reduced the alternatives. It has made the combination of project C and
project D as unfeasible alternative.
Moreover, the ranking of the projects also has been affected by the dependency of project C. Had
there not been any dependent project among the alternatives, all the projects could have been
ranked solely based on their merits. However, in our case we are compelled to consider
dependency condition first and then only other ranking parameters which will not lead us to the
optimum result. So dependent projects should be treated as single projects as explained above.
Question 10
Do you think that the quantitative measures alone are important in capital budgeting
evaluation? What qualitative factors could also be important in capital budgeting
evaluation?
The main objective of any firm is to increase the shareholders wealth and maximize the profits
for the firm. With the quantitative measures of capital budgeting evaluation, the firm tries to
evaluate additional wealth each projects would generate if undertaken. Basically, quantitative
measures only assist on managerial decision by providing the facts and figures for manager to
prove their decisions to be rational. However, for complete evaluation of capital budgeting,
qualitative measures are equally important.
Some of the important qualitative factors in capital budgeting evaluation are as follows:
First of all, the reliability of figures like cash flows, cost of capital etc which help to
evaluate quantitative measures should be ascertained.If these figures are authentic then
only the quantitative measures can be trusted upon.
The vision of judgement of future also plays an important role as factors like market
potential, possibility of technology change, trend of government policies etc considerably
affect capital budgeting process.
Risk associated in all the projects also have to be studied properly and if these risks are
considered then only the outcome capital budgeting process can be reliable.
Annex
Calculation of Payback Period
Project A
Cash Flows
-500,000
136,000
136,000
136,000
618,800
Original Investment
Year 1
Year 2
Year 3
Year 4
Cash Flows
Cumulative Cash Flows
-500,000
-500,000
370,000
-130,000
270,000
140,000
155,000
295,000
49,000
344,000
Cash Flows
Cumulative Cash Flows
-1,000,000
-1,000,000
323,000
-677,000
323,000
-354,000
323,000
-31,000
323,000
292,000
323,000
615,000
323,000
938,000
323,000
1,261,000
323,000
1,584,000
Year 9
Year 10
323,000
323,000
1,907,000
2,230,000
Cash Flows
Cumulative Cash Flows
-500,000
-500,000
175,000
-325,000
175,000
-150,000
175,000
25,000
175,000
200,000
175,000
375,000
Cash Flows
-500,000
136,000
136,000
136,000
618,800
PVIF@21%
1
0.8264
0.683
0.5645
0.4665
PV
-500000
112390.4
92888
76772
288670.2
Cumulative CFs
-500000
-387609.6
-294721.6
-217949.6
70720.6
Cash Flows
-500,000
370,000
270,000
155,000
49,000
PVIF@21%
1
0.8264
0.683
0.5645
0.4665
PV
-500000
305768
184410
87497.5
22858.5
Cumulative CFs
-500000
-194232
-9822
77675.5
100534
Cash Flows
-1,000,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
PVIF@15%
1
0.8696
0.7695
0.6575
0.5718
0.4972
0.4323
0.3759
0.3269
0.2843
PV
-1000000
280880.8
248548.5
212372.5
184691.4
160595.6
139632.9
121415.7
105588.7
91828.9
Cumulative CFs
-500000
-219119.2
29429.3
241801.8
426493.2
587088.8
726721.7
848137.4
953726.1
1045555
10
323,000
0.2472
79845.6
1125400.6
Project D
At 15 % discount rate
Year
0
1
2
3
4
5
Cash Flows
-500,000
175,000
175,000
175,000
175,000
175,000
PVIF@15%
PV
-500000
152180
134662.5
115062.5
100065
139510
1
0.8696
0.7695
0.6575
0.5718
0.7972
Cumulative CFs
-500000
-347820
-213157.5
-98095
1970
141480
Cash Flows
PVIF@21%
PV
Cumulative CFs
0
1
2
3
4
5
-500,000
175,000
175,000
175,000
175,000
175,000
1
0.8264
0.683
0.5645
0.4665
0.3855
-500000
144620
119525
98787.5
81637.5
67462.5
-500000
-355380
-235855
-137067.5
-55430
12032.5
CFs
-500,000
136,000
136,000
136,000
618,800
PVIF @ 26%
1
0.7937
0.6299
0.4999
0.3968
PV
-500000
107943.2
85666.4
67986.4
245539.84
7135.84
PVIF @ 27%
1
0.7874
0.62
0.4882
0.3844
PV
-500000
107086.4
84320
66395.2
237866.72
-4331.68
CFs
-500,000
370,000
270,000
PVIF @ 34%
1
0.7463
0.5569
PV
-500000
276131
150363
PVIF @ 35%
1
0.7407
0.5487
PV
-500000
274059
148149
3
4
NPV
155,000
49,000
0.4156
0.3102
64418
15199.8
6111.8
0.4064
0.3011
62992
14753.9
-46.1
CFs
-1,000,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
PVIF @ 29%
1
0.7752
0.6009
0.4658
0.3611
0.2799
0.217
0.1682
0.1304
0.1011
0.0784
PV
-1000000
250389.6
194090.7
150453.4
116635.3
90407.7
70091
54328.6
42119.2
32655.3
25323.2
26494
PVIF @ 30%
1
0.7692
0.5917
0.4552
0.3501
0.2693
0.2072
0.1594
0.1226
0.0943
0.0725
PV
-1000000
248451.6
191119.1
147029.6
113082.3
86983.9
66925.6
51486.2
39599.8
30458.9
23417.5
-1445.5
CFs
-500,000
175,000
175,000
175,000
175,000
175,000
PVIF @ 22%
1
0.8197
0.6719
0.5507
0.4514
0.37
PV
-500000
143447.5
117582.5
96372.5
78995
64750
1147.5
PVIF @ 23%
1
0.813
0.661
0.5374
0.4369
0.3552
PV
-500000
142275
115675
94045
76457.5
62160
-9387.5