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 riskadjusted 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
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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 3year 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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 Fall '06
 Tapley
 Finance, Net Present Value, Internal rate of return, CFj, capital budgeting examples

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