Capital Budgeting Basics, Build a Model
Model
10/8/20
Build a Model
Sunrise Nursery is considering two mutually exclusive investments. The projects' expected net cash flows are as follows:
Expected net cash flows
Time Project A Project B
0 ($375) ($575)
1 ($300) $190
2 ($200) $190
3 ($100) $190
4 $600 $190
5 $600 $190
6 $926 $190
7 ($200) $0
a. If you were told that each project's discount rate was 12 percent, which project should be selected? If the discount rate was 18 percent, what would be the proper choice?
@ a 12% cost of capital @ a 18% cost of capital
Discount rate = 12% Discount rate 18%
NPV A = NPV A =
NPV B = NPV B =
b. Construct NPV profiles for Projects A and B.
Before we can graph the NPV profiles for these projects, we must create a data table of project NPV relative to differing discount rates.
Project A Project B
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
24%
26%
28%
30%
c. What is each project's IRR?
We find the internal rate of return with Excel's IRR function:
IRR A = Note in the graph above that the X-axis intercepts are equal to the two projects' IRRs.
IRR B =
d. What is each project's MIRR at a rate of 12 percent? At r = 18%? (Hint: Consider Period 7 to be the end of Project B's life.)
@ a 12% cost of capital @ a 18% cost of capital
MIRR A = MIRR A =
MIRR B = MIRR B =
e. What is the crossover rate, and what is its significance?
Cash flow
Time differential Take the cashflow differences of the two projects and calculate IRR to get the cross over rate
0
1
2 Crossover rate =
3
4 The crossover rate represents the cost of capital at which the two projects
5 have the same net present value. In this scenario, that common net present
6 value, at a cost of capital of 13.13%, is:
7
f. What is the regular payback period for these two projects?
Project A
Time period: 0 1 2 3 4 5 6 7
Cash flow: (375) (300) (200) (100) 600 $600 $926 ($200)
Cumulative cash flow:
Payback:
Project B
Time period: 0 1 2 3 4 5 6 7
Cash flow: (575) 190 190 190 190 $190 $190 $0
Cumulative cash flow:
Payback:
g. At a discount rate of 12%, what is the discounted payback period for these two projects?
RATE = 12%
Project A
Time period: 0 1 2 3 4 5 6 7
Cash flow: (375) (300) (200) (100) 600 $600 $926 ($200)
Disc. cash flow:
Disc. cum. cash flow:
Discounted Payback:
Project B
Time period: 0 1 2 3 4 5 6 7
Cash flow: (575) 190 190 190 190 $190 $190 $0
Disc. cash flow:
Disc. cum. cash flow:
Discounted Payback:
Net Present Value of "A" discounted at a WACC of 12%
Net Present Value of "A" discounted at a WACC of 18%
The IRR for the Cash Flow Differential
The difference in cash flows between project "A" and project "B".
Use Excel's MIRR function