Question: Case Study 3--Capital Budgeting (Comprehensive Spreadsheet Problem 11-23, page 408) Your division is considering two projects. Its WACC is 10%, and the projects' after-tax cash
| Case Study 3--Capital Budgeting | |||||||||
| (Comprehensive Spreadsheet Problem 11-23, page 408) | |||||||||
| Your division is considering two projects. Its WACC is 10%, and the projects' after-tax cash flows (in millions | |||||||||
| of dollars) would be as follows: | |||||||||
| Expected Cash Flows | |||||||||
| Time | Project A | Project B | |||||||
| 0 | ($30) | ($30) | |||||||
| 1 | $5 | $20 | |||||||
| 2 | $10 | $10 | |||||||
| 3 | $15 | $8 | |||||||
| 4 | $20 | $6 | |||||||
| a. Calculate the projects' NPVs, IRRs, MIRRs, regular paybacks, and discounted paybacks. | |||||||||
| WACC = | 10% | Use Excel's NPV function as explained in | |||||||
| NPVA = | 11model.xlsx. Note that the range does not include | ||||||||
| NPVB = | the initial costs, which are added separately. | ||||||||
| We find the internal rate of return with Excel's IRR function: | |||||||||
| IRRA = | |||||||||
| IRRB = | |||||||||
| We find the modified internal rate of return with Excel's MIRR function using the 10% WACC: | |||||||||
| MIRRA = | |||||||||
| MIRRB = | |||||||||
| Project A Payback Period: | |||||||||
| Time period: | 0 | 1 | 2 | 3 | |||||
| Cash flow: | |||||||||
| Cumulative cash flow: | |||||||||
| PaybackA: | |||||||||
| Project B Payback Period: | |||||||||
| Time period: | 0 | 1 | 2 | 3 | |||||
| Cash flow: | |||||||||
| Cumulative cash flow: | |||||||||
| PaybackB: | |||||||||
| Project A Discounted Payback Period: | |||||||||
| Time period: | 0 | 1 | 2 | 3 | |||||
| Cash flow: | |||||||||
| Disc. cash flow: | |||||||||
| Disc. cum. cash flow: | |||||||||
| Discounted PaybackA: | |||||||||
| Project B Discounted Payback Period: | |||||||||
| Time period: | 0 | 1 | 2 | 3 | |||||
| Cash flow: | |||||||||
| Disc. cash flow: | |||||||||
| Disc. cum. cash flow: | |||||||||
| Discounted PaybackB: | |||||||||
| b. If the two projects are independent, which project(s) should be chosen? | |||||||||
| c. If the two projects are mutually exclusive and the WACC is 10%, which project(s) should be chosen? | |||||||||
| d. Plot NPV profiles for the two projects. Identify the projects' IRRs on the graph. | |||||||||
| Hint: Before you can graph the NPV profiles for these projects, you must create a data table of project NPV relative to | |||||||||
| differing costs of capital--use Excel's NPV formula and the space below to do so. The graph will automatically create, | |||||||||
| as values are added. | |||||||||
| Project A | Project B | ||||||||
| $0.00 | $0.00 | ||||||||
| 0.00% | |||||||||
| 2.00% | |||||||||
| 4.00% | |||||||||
| 6.00% | |||||||||
| 8.00% | |||||||||
| 10.00% | |||||||||
| 12.00% | |||||||||
| 14.00% | |||||||||
| 16.00% | |||||||||
| 18.00% | |||||||||
| 19.19% | |||||||||
| 20.00% | |||||||||
| 22.00% | |||||||||
| 22.52% | |||||||||
| 24.00% | |||||||||
| e. If the WACC was 5%, would this change your recommendation if the projects were mutually exclusive? | |||||||||
| If the WACC was 15%, would this change your recommendation? Explain your answers. | |||||||||
| f. The "crossover rate" is 13.5252%. Explain what this rate is and how it affects the choice between | |||||||||
| mutually exclusive projects. | |||||||||
| g. Is it possible for conflicts to exist between the NPV and the IRR when independent projects are being evaluated? | |||||||||
| Explain your answer. | |||||||||
| h. Now, look at the regular and discounted paybacks. Which project looks better when judged by the paybacks? | |||||||||
| i. If the payback was the only method a firm used to accept or reject projects, what payback should it choose | |||||||||
| as the cutoff point, that is, reject projects if their paybacks are not below the chosen cutoff? Is your selected | |||||||||
| cutoff based on some economic criteria, or is it more or less arbitrary? Are the cutoff criteria equally | |||||||||
| arbitrary when firms use the NPV and/or the IRR as the criteria? Explain. | |||||||||
| j. Define the MIRR. What's the difference between the IRR and the MIRR, and which generally gives a better | |||||||||
| idea of the rate of return on the investment in a project? Explain. | |||||||||
| k. Why do most academics and financial executives regard the NPV as being the single best criterion and | |||||||||
| better than the IRR? Why do companies still calculate IRRs? | |||||||||
Step by Step Solution
There are 3 Steps involved in it
Get step-by-step solutions from verified subject matter experts
Study Help