Question

2 Assume that you are a new analyst hired to evaluate the capital budgeting projects of the company which is considering investing in two CPEC projects, “Expansion Zone North” and “Expansion Zone East”. The initial cost of each project is Rs. 10,000. Company discount all projects based on WACC. Further, all the projects are equally risky projects and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at an interest rate of rd 10% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. The dividend for next period is $2.0, its expected that they will grow at the constant growth rate of 8%, and the company’s common stock sells for $20. The tax rate is 50%.

The cash flows of both the projects are given in table below:

Time	Expansion Zone North Cashflows (amount in Rs.)	Expansion Zone East Cashflows (amount in Rs.)
0	10,000	10,000
1	6,500	3,500
2	3,000	3,500
3	3,000	3,500
4	1,000	3,500

Carefully analyze the above table and answer the following questions in detail.

1. Calculate the weighted average cost of capital for this firm? (2.5 marks)
2. Compute each project’s IRR, NPV, payback, MIRR, and discounted payback. (2.5 Marks)
3. Which project(s) should be accepted if they are mutually exclusive? Explain (1.5 Marks)
4. Which project(s) should be accepted if they are independent? Explain (1.5 Marks)

Answer 1

Solution:-

Cost of Equity (ke) = (d​​​​​​1​​​​​/P)+ g

d​​​​​​1= Expected dividend

g = Growth rate

P= Current Price

In this manner, ke= 2/20 + .08 = 18%

Kd = post charge cost of obligation = 10(1-.5) = 5%

WACC = weight of equity*ke +weight of debt*kd

= .5*.18+.5*.05 = 11.5%

2 ) IRR :

0 = NPV= Ct ÷ (1+IRR)t

where t= timespan, C= income

Presently by subbing the income and timespan we will get IRR.

In like manner by subbing the figures of the 2 ventures we get

IRR of Expansion zone North = 18.03%

IRR of Expansion zone East = 14.96%

NPV = PV of Cash inflows - Cash outpouring

NPV of Expansion zone North:

= 6500/(1.115)+3000/(1.115)²+3000/(1.115)³+1000/(1.115)⁴ - 10000

=1053.87

Also NPV of Expansion zone East :

=3500/(1.115)+3500/(1.115)²+3500/(1.115)³+3500/(1.115)⁴ - 10000

=743.65

MIRR = (Future estimation of positive income at WACC/PV of negative income at financing cost of the company)1/n - 1

MIRR of Expansion zone North=[{6500*(1.115)³+3000*(1.115)²+3000*(1.115)¹+1000} ÷ 10000]1/4 - 1 = 14.33%

Additionally MIRR of East zone = [{3500*(1.115)³+3500*(1.115)²+3500*(1.115)+3500} ÷10000]1/4-1

=13.52%

Limited money inflow of North zone venture :

Time Amount Present [email protected]% of Amount

1 6500. 5830

2. 3000. 2413

3. 3000. 2164

4. 1000. 647

Limited recompense period = 2 years + 1757/2165

= 2.81 years

Limited money inflow of East Zone

Time. Sum. Present [email protected]% of sum

1. 3500. 3139

2. 3500. 2815

3. 3500. 2525

4. 3500. 2265

Limited restitution period = 3 years + 1521/2265

= 3.67 years

3. ) The undertaking with the most noteworthy NPV must be picked as it makes the most noteworthy incentive for the firm.

Thus Project North Zone must be chosen as it's having the most elevated NPV we can likewise observe North zone is having better IRR MIRR and Discounted compensation period than Project East Zone.

4. ) If ventures are free then the activities with Positive NPV must be picked.

Henceforth both North Zone and East Zone can be chosen