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Capital Budgeting Examples with Solutions-SUMMER2010

# Capital Budgeting Examples with Solutions-SUMMER2010 -...

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Capital Budgeting - Example 1 You are analyzing a project that has the following distribution of potential cash flows (initial and conditional probabilities are in parentheses): Year 0 Year 1 Year 2 \$ 300 (.2) \$ 500 (.4) \$ 500 (.6) \$ 700 (.2) -\$ 800 \$1,000 (.3) \$1,200 (.6) \$1,200 (.4) \$1,400 (.3) If the appropriate risk-adjusted discount rate to use for this project is 15 percent, then what are the net present value (NPV) and internal rate of return (IRR) for this project? Calculate expected cash flows: Year 0 = -\$800 Year 1 = (\$500)(.4) + (\$1,200)(.6) = \$920 Year 2 = [(\$300)(.2) + (\$500)(.6) + (\$700)(.2)][.4] + [(\$1,000)(.3) + (\$1,200)(.4) + (\$1,400)(.3)][.6] = [\$500][.4] + [\$1,200][.6] = \$920 CFj = -\$800 CFj = \$920 CFj = \$920 I/YR = 15 Solve for NPV = \$695.65 Solve for IRR = 79.18% Capital Budgeting Examples - Solutions Page 1

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Capital Budgeting - E xample 2 You are analyzing the following two mutually exclusive projects, where Project A is a 4- year project and Project B is a 3-year project: Project A Project B Year Cash Flows Cash Flows 0 -\$1,000 -\$ 800 1 +350 +350 2 +400 +400 3 +400 +400 4 +400 ----- Assume that the cost of capital is 15% and that you use the Equivalent Annual Annuity (EAA) method to evaluate these projects under infinite replication. Which project will dominate in terms of NPV and by how much?
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