Time Value of Money and Capital Budgeting (Case Study Sample)

TVM AND CAPITAL BUDGETING
INSERT NAME
INSTITUTIONAL AFFILIATION
Part 1
The payback period, IRR, MIRR, NPV, and PI for the following two mutually exclusive projects. The required rate of return is 15% and the target payback is 4 years. Explain which project is preferable under each of the four capital budgeting methods mentioned above:
,
YearInvestment AInvestment B cumulative cash flow
A B
0-$5,000,000-5,000,000
1$1,500,000$1,250,000 $1,500,000 $1,250,000
2$1,500,000$1,250,000 $3,000,000 $2,500,000
3$1,500,000$1,250,000 $4,500,000 $3,750,000
4$1,500,000$1,250,000 $5,000,000
5$1,500,000$1,250,000
6$1,500,000$1,250,000
7$2,000,000$1,250,000
80$1,600,000
Payback period,
Initial investment =
left1714500Payback = Number of years before full + Amount of investment unrecovered at start
320992522098000 recovery of initial investmentof the recovery year
Total cash flow generated during the recovery year
INVESTMENT A INVESTMENT B
3+(5000,000-4500,000)/1500,000=3.33 or 3 years 4 months 3+(5000,000-3750,000)/1250,000=4years
Based on payback period, investment A is acceptable due to lower payback period although investment B is still acceptable because it has expected payback period of 4 years .
IRR=a+[NPVa/NPVa-NPVb](b-a)
Our a is 15% ,we can say let our b =17%
Present value of uniform cash flows =P = A [ (1 + i) n - 1 ] / [ i (1 + i) n ]
Investment A
NPVa
P=1500,000[(1.15)^6 -1]/[0.15(1.15)^6]
1500,000[1.313060766/0.346959114]=5,676,724+PV for year 7 and 8 2000,000(1.15)^-7 +0(1.15)^-8=$6,428,598-5000,000=NPVa=$1,428,598
NPVb
P=1500,000[(1.17)^6 -1]/[0.17(1.17)^6]
1500,000[1.565164202/0.436077913]=5,383,777+PV for year 7 and year 8 2000,000(1.17)^-7+0(1.17)^-8=6,050,168-5000,000=1050168=NPV b
Investment A IRR=15%+[1428598/1428598-1050168](17%-15%)=15.08%
IRR for investment A =15.08%
INVSTMENT B
NPVa=
P=1,250,000[(1.15)^7-1]/[0.15(1.15)^7]
1250,000[1.66001988/0.399002982]=5,200,525 +PV for year 8 1600,000(1.15)6-8=5,723,568-5000,000=723,568 =NPVa
NPVb
P=1,250,000[(1.17)^7-1]/[0.17(1.17)^7]
=1250,000[2.001242116/0.510211159]=4,902,975 +PV year 8 1600,000 (1.17^8)=5,358,627-5000,0000=358,627 NPVb
IRR for investment B=
15%+[723,568/723,568-358,627](2) =15.03%
Based on IRR, accept investment A because it has higher rate than discount rate .Investment B is still acceptable due to IRR higher rate than discount rate of 15% but A has a higher IRR than B
MIRR = (Future value of positive cash flows / present value of negative cash flows) (1/n) – 1.
There are no negative cash flows in both investment A and B hence future value of Negative cash flows is 0 thus MIRR not possible hence no decision can be made here .
NPV
NPV investment A =$1,428,598
NPV investment B =$723,568
All these are calculated as NPVa in working out IRR
Based on NPV, accept investment B due to positive higher NPV than Investment A.
PI = PV of cash inflow/ Initial cash outlay
PI Investment A = 1,428,598/5000,000=0.29
PI investment B=$723,568/5000,000=0.14
Based on PI, accept investment A because it has a higher PI index.
Part 2
•Explain how you determine the initial cash flows
Initial cash flows refers to amount of money your require to obtain a new asset, could be office machinery in the company for instance.
Initial cash flows will be obtained by:
Initial investment =initial investment needed to acquire the asset –after tax cash inflows from liquidation of old asset.
In this our case initial investment to acquire new asset =$3.5 million
•Discuss the notion of sunk costs and identify the sunk cost in this project
The notion of sunk costs refer to cash outlays which have already been made ,that is past outlays and therefore have no effect on cash flows relevant to a current decision .Sunk costs should not be included in the project’s incremental cash flows. Sunk costs in this case entail $2.1million cost of land bought three years ago in anticipation of using it as a toxic waste dump site, $125,000 paid to marketing firm to analyze Zither market.
•Verify how you determine the annual operating cash flows
Annual operating cash flows are determined by getting operating cash flows from new asset -operating cash flows from old asset
Year 0 ($3,500,000)
Year 1 3,600 *$750 =$2,700,000-$415,000-15% sales ($2,700,000)-tax $714,400 +MACRS depreciation year 1 33%*$3,500,000 -($125,000 net working capital ) =$2,195,600
Year 2 4,300*$750=$3,225,000-$415,000-15% sales ($3,225,000)-883,975+ MACRS depreciation year 1 44.45%*$3,500,000=$2,998,025
Year 3 5,200*$750=$3,900,000-$415,000-15% sales ($3,900,000) –tax $1,102,000+ MACRS depreciation year 1 14.81%*$3,500,000=$2,316,350
Year 4 3,900*750=$2,925,000-$415,000 fixed cost -15% sales ($2,925,000)-787,075 +salvage value $350,000 +$125,000(net working capital )=$1,759,17