Capital Budgeting Techniques
Problem 1:
Cash flow streams for two mutually exclusive projects are given below.
After-Tax Cash Inflows
Year Project A Project B
1 $300 $600
2 $400 $200
3 $ 50 $100
4 $ 50 $700
Project A requires an initial investment of $600, and project B requires
an initial investment of $1,000.
a. Use the payback period to determine which project should be selected.
b. If the opportunity cost is 8%, determine the net present value for both
projects.
c. Which project should be chosen? What are the drawbacks of the payback
period method?
Problem 2:
Michael’s Costumes is analyzing two mutually exclusive projects. Both require an initial investment of $65,000 and provide cash inflows as follows:
After-Tax Inflows
Year Project C Project D
1 $40,000 0
2 30,000 0
3 20,000 $104,200
a. If the opportunity cost is 10 percent, which product would Michael’s choose if NPV is employed?
b. Calculate the internal rate of return for both projects. Which project should be selected according to IRR? Why does the difference in ranking occur?
Problem 3:
Terra Products has the following independent investments under examination:
Initial After-Tax Cash Life of the
Project Investment Flow per Year Project (in years)
A $100,000 $ 39,000 4
B 50,000 12,000 6
C 80,000 39,000 3
D 60,000 15,000 7
E 75,000 25,000 5
F 90,000 25,000 6
Terra Products’ opportunity cost of capital is 14 percent.
a. In the absence of capital rationing, which projects should be selected? What is the size (in total dollars) of the capital budget? The total NPV of all of the projects selected?
b. Now suppose that a limit of $250,000 (maximum)is placed on new capital projects. Which projects should be selected?
c. What is the total NPV determined in (b)? What is the loss to Terra Products due to the capital rationing constraint?