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Microsoft Word - Capital Budgeting HW.docx BUSB-361 CapitalBudgetingProblems UniversityofRedlands Prof.Ambrose...

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Microsoft Word - Capital Budgeting HW.docx
BUSB-361        
Capital    Budgeting    Problems    
University    of    Redlands    
Prof.    Am
ose    
    
1)    For    each    option,    calculate    the    NPV,    IRR    and    payback    period    assuming    the    cost    of    capital    is    6%    
    
• If    these    were    independent    projects,    which    would    you    recommend    the    firm    do?        
    
    
• If    these    were    mutually    exclusive    projects,    which    would    you    prefer?        
    
    
    
• How    would    your    answer    change    if    the    cost    of    capital    increased    to    15%?            
    
• Explain    what    is    happening    in    the    second    scenario    versus    the    first    scenario.    (Why    is    there    
a    difference    in    the    second    scenario    versus    the    first?)    
    
    
    
2)    You    have    a    choice    between    two    machines.        Both    machines    do    the    same    job,    both    last    the    
same    period    of    time,    both    have    zero    scrap    value.        Future    costs    are    discounted    at    9%    
(compounded    annually).    
    
    
    
Machine    A    –    Costs    $10,000    initially,    plus    expected    maintenance    costs    of    $200/year    for    the    next    
10    years    (starting    next    year).        
    
    
    
Machine    B    –    Costs    $11,000    initially,    plus    expected    maintenance    costs    of    $100/year    for    the    next    
10    years    (starting    next    year).    
    
    
    
At    these    prices,    which    machine    would    you    prefer?        
At    what    price    for    machine    B    would    you    be    indifferent    between    machines    A    and    B?    
    
    
    
    
3)    A    pharmaceutical    company    will    spend    $2,000,000    each    year    for    3    years    to    develop    a    new    
drug    (years    0,    1,    2).        After    that    (starting    year    3),    they    will    earn    $800,000    in    profits    per    year    for    
the    next    10    years    before    the    patent    runs    out.        Once    the    patent    is    gone    they    do    not    expect    to    
earn    any    additional    profits    off    this    drug.        If    future    payments    are    discounted    using    an    11%    
interest    rate    (compounded    annually),    is    this    new    drug    a    profitable    venture?    
    
    
    
    
    
4)    The    initial    cost    of    developing    a    project    in    year    0    is    $100,000.        You    expect    to    sell    3,000    units    
per    year    over    the    next    5    years    (years    1    to    5)    at    a    profit    of    $10    per    unit.        Given    an    interest    rate    of    
7%,    what    is    the    NPV    of    this    project?        How    many    units    would    you    have    to    sell    to    
eak    even    in    
terms    of    NPV?        If    we    assumed    that    you    sold    3,000    units    per    year,    what    profit    per    unit    would    
eak    even    in    terms    of    NPV?    
    
    
    
    
    
5)    You    are    evaluating    the    NPV    of    a    project    to    expand    sales    into    a    new    region.        The    cost    of    the    
expansion    is    paid    in    year    0.        The    benefits    of    the    expansion    start    in    year    1    and    last    for    10    years,    
after    which    they    end.        Profits    are    determined    by    multiplying    net-profit-per-unit    by    the    amount    
of    sales.        There    is    some    uncertainty    about    the    cost    and    other    parameters.        We    have    high,    low    
and    base    (most    likely)    estimates    for    each    of    the    parameters.    
    
    
a)    The    annual    interest    rate    is    5%.        What    is    the    NPV    at    the    base    values    of    the    parameters?                
    
)    Show    how    sensitive    the    results    are    to    the    assumptions    about    sales,    net-profits-per-unit,    and    
cost    (use    the    high    and    low    values    of    the    appropriate    parameters    to    determine    sensitivity).    
    
c)    Do    a    scenario    analysis    and    determine    the    NPV    for    the    best    and    worst    cases.    (What    
combination    of    results    is    best?    What    combination    is    worst?)
Answered Same DayDec 15, 2021

Solution

Mohammad Wasif answered on Dec 16 2021
53 Votes
1
        Year    A     B     C    PV @ 6%    Cashflow of A    Cashflow of B    Cashflow of C
        0    $ (10,000)    $ (10,000)    $ (10,000)    1.0000    $ (10,000.00)    $ (10,000.00)    $ (10,000.00)
        1    $ 5,000    $ 3,900    $ 2,600    0.9434    $ 4,716.98    $ 3,679.25    $ 2,452.83
        2    $ 5,000    $ 3,900    $ 2,600    0.8900    $ 4,449.98    $ 3,470.99    $ 2,313.99
        3    $ 5,000    $ 3,900    $ 2,600    0.8396    $ 4,198.10    $ 3,274.52    $ 2,183.01
        4        $ 3,900    $ 2,600    0.7921        $ 3,089.17    $ 2,059.44
            NPV                $ 3,365.06    $ 3,513.91    $ (990.73)
            IRR                16.39%    13.69%    -4.16%
        Year    A     B     C    Cumulative Cashflow of A    Cumulative Cashflow of B    Cumulative Cashflow of C
        0    $ (10,000)    $ (10,000)    $ (10,000)    $ (10,000)    $ (10,000)    $ (10,000)
        1    $ 5,000    $ 3,900    $ 2,600    $ (5,000)    $ (6,100)    $ (7,400)
        2    $ 5,000    $ 3,900    $ 2,600    $ - 0    $ (2,200)    $ (4,800)
        3    $ 5,000    $ 3,900    $ 2,600    $ 5,000    $ 1,700    $ (2,200)
        4        $ 3,900    $ 2,600        $ 5,600    $ 400
            Payback            2.00    2.56    3.85
        Independent: Do project A and B but not C
        Mutually Exclusive: Project B
        Year    A     B     C    PV @ 15%    Cashflow of A    Cashflow of B    Cashflow of C
        0    $ (10,000)    $ (10,000)    $ (10,000)    1.0000    $ (10,000.00)    $ (10,000.00)    $ (10,000.00)
        1    $ 5,000    $ 3,900    $ 2,600    0.8696    $ 4,347.83    $ 3,391.30    $ 2,260.87
        2    $ 5,000    $ 3,900    $ 2,600    0.7561    $ 3,780.72    $ 2,948.96    $ 1,965.97
        3    $ 5,000    $ 3,900    $ 2,600    0.6575    $ 3,287.58    $ 2,564.31    $ 1,709.54
        4        $ 3,900    $ 2,600    0.5718        $ 2,229.84    $ 1,486.56
            NPV                $ 1,416.13    $ 1,134.42    $ (2,577.06)
            IRR                7.28%    4.79%    -11.66%
        A is better than B since the payments for B (on average) are coming farther in the future and so are more heavily discounted by the higher interest rate.
2
    For Machine A
    Initial Cost    $ 10,000
    Discounted Rate    9%
    Number of Years    10
    Maintenance Costs    $ 200
    Present Value    $1,283.53
    Total Cost    $ 11,283.53
    For Machine B
    Initial Cost    $ 11,000
    Discounted Rate    9%
    Number of Years    10
    Maintenance Costs    $ 100
    Present Value    $641.77
    Total Cost    $ 11,641.77
    A is economical. If B sold for 11,641.76 they would have the same cost
3
        Interest Rate    11%
        Year    Cost    PV @ 11%    Total Cashflow
        0    $ 2,000,000    1    $ 2,000,000.00
        1    $ 2,000,000    0.9009009009    $ 1,801,801.80
        2    $ 2,000,000    0.8116224332    $ 1,623,244.87
        NPV            $ 5,425,046.67
        For Benefits:
        i    11%
        n    10
        PMT    $ 800,000
        Present Value    $ 4,711,385.61
        To convert the year 2 pv to year 0            PV    $ 3,823,866.25
        NPV    $ (1,601,180.42)
        Since,, NPV is negative. Hence, do not develop the drug
4
        Interest Rate    7%
        Year    Cashflow    PV    PV of Cashflow
        0    $ (100,000)    1    $ (100,000.00)
        1    $ 30,000    0.9345794393    $ 28,037.38
        2    $ 30,000    0.8734387283    $ 26,203.16
        3    $ ...
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