CH08Problems - Understanding Financial Management A...

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1 Understanding Financial Management: A Practical Guide Problems and Answers Chapter 8 Capital Budgeting 8.2 – 8.8 Capital Budgeting Techniques (NPV, PI, IRR, MIRR, PP, and DPP) 1. Fair Trade Tea Company (FTTC) is considering investing $200,000 to expand its operations. The firm’s required rate of return is 12% and the firm expects to reinvest any cash inflows at this rate. Management has set the maximum payback period as 3 years and the maximum discounted payback period at 4 years. The firm estimates that year-end cash flows will be as follows: Fair Trade Tea Company Net Cash Flows Year 0 1 2 3 4 5 Net cash flow -$200,000 $50,000 $54,000 $60,000 $68,000 $75,000 Using each of the follow techniques, should the firm accept the project? Why or why not? A. Net present value B. Profitability index C. Internal rate of return D. Modified internal rate of return E. Payback period F. Discounted payback period 2. Coltrane Recordings is considering investing in a new project with an unconventional cash flow pattern. The company’s cost of capital is 13% and the firm expects to reinvest any cash inflows at this rate. Management has set the maximum discounted payback period at 4 years. The initial investment and year-end cash flows are listed below. Coltrane Recordings Net Cash Flows Year 0 1 2 3 4 5 Net cash flow -$500,000 $160,000 $180,000 $-60,000 $220,000 $260,000 Using each of the following discounted cash flow techniques, should the firm accept the project? Why or why not? A. Net present value B. Profitability index C. Internal rate of return D. Modified internal rate of return F. Discounted payback period
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