Question

Please note that this assignment consists of two separate parts. The first part gives the cash flows for two mutually exclusive projects and is not related to the second part. The second part is a capital budgeting scenario.

Part 1

Please calculate 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:

Table 1

Cash flows for two mutually exclusive projects

Year	Investment A	Investment B
0	-$5,000,000	-5,000,000
1	$1,500,000	$1,250,000
2	$1,500,000	$1,250,000
3	$1,500,000	$1,250,000
4	$1,500,000	$1,250,000
5	$1,500,000	$1,250,000
6	$1,500,000	$1,250,000
7	$2,000,000	$1,250,000
8	0	$1,600,000

Part 2

Please study the following capital budgeting project and then provide explanations for the questions outlined below:

You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago for $2.1 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $2.3 million on an after-tax basis. In four years, the land could be sold for $2.4 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $125,000. An excerpt of the marketing report is as follows:

The zither industry will have a rapid expansion in the next four years. With the brand name recognition that PUTZ brings to bear, we feel that the company will be able to sell 3,600, 4,300, 5,200, and 3,900 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $750 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued. PUTZ believes that fixed costs for the project will be $415,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $3.5 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $350,000. Net working capital of $125,000 will be required immediately. PUTZ has a 38% tax rate, and the required rate of return on the project is 13%.

Now please provide detailed explanation for the following:

• Explain how you determine the initial cash flows

• Discuss the notion of sunk costs and identify the sunk cost in this project

• Verify how you determine the annual operating cash flows

• Explain how you determine the terminal cash flows at the end of the project’s life

• Calculate the NPV and IRR of the project and decide if the project is acceptable

• If the company that is implementing this project is a publicly traded company, explain and justify how this project will impact the market price of the company’s stock

Provide your explanations and definitions in detail and be precise. Comment on your findings. Provide references for content when necessary. Provide your work in detail and explain in your own words. Support your statements with peer-reviewed in-text citation(s) and reference(s).

Answer 1

Part 1:

Based on the given data, pls find below steps, workings and answers:

Payback period of Investment A is 3.33 years and that of Investment B is 4 years

NPV of Investment A is $ 1428598.12 and that of Investment B is $ 723567.51

PI of Investment A is $ 28.6% and that of Investment B is 14.5%

IRR of Investment A is 23.8% and that of Investment B is 19.19%

MIRR of Investment A is 19.2% and that of Investment B is 16.96%

Since these are mutually exclusive projects, based on the above criteria, Investment A is more feasible for recommendation than Investment B, as all the factors are higher than Investment B and the Payback period is lower than Investment B;

Computation of IRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%);

Computation of MIRR: This can be computed using formula in Excel = MIRR("range of cashflows", discounting factor%, reinvestment factor%); Here, both discounting factor % and reinvestment factor% are considered same.

Computation of Net Present Value (NPV) based on the Discounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) ; Year 2 = Year 1 factor/(1+discounting factor %) and so on;

Next, the cashflows need to be multiplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;

Computation of Normal / Discounted Pay Back Period: Here, the period is computed for each project, based on cumulative normal /discounted cash flows: If the cumulative value is less than or equal to zero, the period is considered as 12 months (it means that the net cumulative cash flow has not yet paid back the initial investment); Once the value turns positive in a particular year, the period for such year is observed at a proportion of actual discounted cash flow to the cumulative CF; This gives the period less than 12 months in such year; Once this is computed, total of all the years is taken and divided by 12, to arrive at the Payback period in no.of years.

Part 2:

Based on the given data, pls find below steps, workings and answers:

• Explain how you determine the initial cash flows: Only the cost of Equipment and the increase in the net working capital should be considered as cash outflows; Although the land can be sold, the same is being replaced with a separate contract with a different company to handle the toxic waste; Hence, it is evident that these land (handling toxc waste) and this product (market) of zither are different. Hence, the proceeds from the sale of land not to be considered here.

• Discuss the notion of sunk costs and identify the sunk cost in this project: The marketing costs are already spent and hence these are considered as sunk costs in this project; Sunk costs are not required to be considered as part of the Projected financials/Capital Budgeting techniques.

• Verify how you determine the annual operating cash flows: As provided below in the workings (Net Income + Depreciation + working Capital changes)

• Explain how you determine the terminal cash flows at the end of the project’s life: As provided below in the workings (Net Income + Depreciation + working Capital changes + After Tax salvage value)

• Calculate the NPV and IRR of the project and decide if the project is acceptable: NPV is $ 1831717.37 and the IRR is 35.22%; Since, the NPV is positive and the IRR is higher than the Cost of Capital, this Project is acceptable.

• If the company that is implementing this project is a publicly traded company, explain and justify how this project will impact the market price of the company’s stock: This will have a positive impact on the stock price, as there shall be new product/market in to which the company is progressing as well as the internal accruals are being used for the expansion of the operationsl of the company. Hence, this shall be considered as a positive news for the Stock market.

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