Solutions-CapitalBudgeting_PracticeProblems

Solutions-CapitalBudgeting_PracticeProblems - BUSI408:...

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BUSI408: CORPORATE FINANCE Capital Budgeting Practice Problems - Solutions Instructor: Serdar Aldatmaz ____________________________________________________________________________________ _ Chapter 9 17. a . The payback period for each project is: A: 3 + ($180,000/$390,000) = 3.46 years (assuming that $390,000 is received uniformly throughout the 4 th year) B: 2 + ($9,000/$18,000) = 2.50 years (assuming that $18,000 is received uniformly throughout the 3 rd year) The payback criterion implies accepting project B, because it pays back sooner than project A. b. The discounted payback for each project is: A: $20,000/1.15 + $50,000/1.15 2 + $50,000/1.15 3 = $88,074.30 $390,000/1.15 4 = $222,983.77 Discounted payback = 3 + ($300,000 – 88,074.30)/$222,983.77 = 3.95 years (uniform CFs) B: $19,000/1.15 + $12,000/1.15 2 + $18,000/1.15 3 = $37,430.76 $10,500/1.15 4 = $6,003.41 Discounted payback = 3 + ($40,000 – 37,430.76)/$6,003.41 = 3.43 years (uniform CFs) The discounted payback criterion implies accepting project B because it pays back sooner than A. c . The NPV for each project is: A: NPV = –$300,000 + $20,000/1.15 + $50,000/1.15 2 + $50,000/1.15 3 + $390,000/1.15 4 NPV = $11,058.07 B: NPV = –$40,000 + $19,000/1.15 + $12,000/1.15 2 + $18,000/1.15 3 + $10,500/1.15 4 NPV = $3,434.16 NPV criterion implies we accept project A because project A has a higher NPV than project B. d. The IRR for each project is: A: $300,000 = $20,000/(1+IRR) + $50,000/(1+IRR) 2 + $50,000/(1+IRR) 3 + $390,000/(1+IRR) 4
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Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 16.20%
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B: $40,000 = $19,000/(1+IRR) + $12,000/(1+IRR) 2 + $18,000/(1+IRR) 3 + $10,500/(1+IRR) 4 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 19.50% IRR decision rule implies we accept project B because IRR for B is greater than IRR for A. e. The profitability index for each project is: A: PI = ($20,000/1.15 + $50,000/1.15 2 + $50,000/1.15 3 + $390,000/1.15 4 ) / $300,000 = 1.037 B: PI = ($19,000/1.15 + $12,000/1.15 2 + $18,000/1.15 3 + $10,500/1.15 4 ) / $40,000 = 1.086 Profitability index criterion implies to accept project B because its PI is greater than project A’s. f. In this instance, the NPV criteria implies that you should accept project A, while profitability index, payback period, discounted payback, and IRR imply that you should accept project B. The final decision should be based on the NPV since it does not have the ranking problem associated with mutually exclusive projects that the other capital budgeting techniques have. Therefore, you should accept project A. As we’ve talked, whenever there is a conflict between NPV and any other criteria, you should always stick to NPV! 25.
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Solutions-CapitalBudgeting_PracticeProblems - BUSI408:...

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