Question

Capital Budgeting Decisions					Instructor:
				FINC 33100
Learning Objectives
1. Understand how to use EXCEL Spreadsheet
(a) Develop proforma Income Statement Using Excel Spreadsheet
(b) Compute Net Project Cashflows, NPV, and IRR
(c) Develop problem-solving and critical thinking skills
	and make long-term investment decisions
1) Life Period of the Equipment = 4 years				8) Sales for first year (1)			$        200,000
2) New equipment cost			$(200,000)	9) Sales increase per year			5%
3) Equipment ship & install cost			$ (35,000)	10) Operating cost (60% of Sales)			$      (120,000)
4) Related start up cost			$    (5,000)	(as a percent of sales in Year 1)			-60%
5) Inventory increase			$    25,000	11) Depreciation			Use 3-yr MACRIS
6) Accounts Payable increase			$      5,000	12) Marginal Corporate Tax Rate (T)			21%
7) Equip. salvage value before tax			$    15,000	13) Cost of Capital (Discount Rate)			10%
ESTIMATING Initial Outlay (Cash Flow, CFo, T= 0)
			CF0	CF1	CF2	CF3	CF4
Year			0	1	2	3	4
Investments:
1) Equipment cost
2) Shipping and Install cost
3) Start up expenses
Total Basis Cost (1+2+3)
4) Net Working Capital
Total Initial Outlay
Operations:
Revenue
Operating Cost
Depreciation
EBIT
Taxes
Net Income
Add back Depreciation
Total Operating Cash Flow				XXXXX	XXXXX	XXXXX	XXXXX
Terminal:
1) Change in net WC				$         -	$       -	$           -	$     20,000
2) Salvage value (after tax)			Salvage Value Before Tax (1-T)				XXXXX
Total							XXXXX
Project Net Cash Flows			$         -	$         -	$       -	$           -	$
NPV =			IRR =			Payback=
Profitability Index =						Discounted Payback =
Q#1	Would you accept the project based on NPV, IRR?
	Would you accept the project based on Payback rule if project cut-off
	is 3 years?
Q#2     Impact of 2017 Tax Cut Act on Net Income, Cash Flows and
	Capital Budgeting (Investment ) Decisions
(a)	Estimate NPV, IRR and Payback Period of the project if equipment is fully
	depreciated in first year and tax rate equals to 21%. Would you
	accept or reject the project?
( b)	As a CFO of the firm, which of the above two scenario (a) or (b)
	would you choose? Why?
Q#3   How would you explain to your CEO what NPV means?
Q#4   What are advantages and disadvantages of using only Payback method?
Q#5   What are advantages and disadvantages of using NPV versus IRR?
Q#6 Explain the difference between independent projects and mutually exclusive projects.
	When you are confronted with Mutually Exclusive Projects and have coflicts
	with NPV and IRR results, which criterion would you use (NPV or IRR) and why?

Answer 1

Answer to Question 1:

I will accept a project if capital budgeting decision is taken on the basis of Net Present Value (NPV) only. Because Internal Rate of Return (IRR) is a measure to find the rate of return only whereas NPV helps you to find out if the project will produce a positive NPV and a higher NPV. You will be able to arrive at exact amount of NPV the project will produce. If it is positive, one can go ahead with the project. If it is negative, the project may be dropped.

Answer to Question 2: I can accept a project based on Payback period technique of capital budgeting for a period of 3 years. Here, you will be able to find out if the cash outflow is earned at the end of 3 years period. However, post payback period profit will not be taken into consideration. So, if cash inflow details are available for a longer period than 3 years, it would be better to calculate post payback period index also so that that will reveal the surplus profits after 3 years period. If Discounted Payback is adopted, we would be able to arrive at the present value of the cash flows of the project.

Answer to Question 2. (a): Yes, the project can be accepted.

Answer to Question 2. (b): If the payback period is achieved, IRR is well over cost of capital and if the NPV is positive, the project can be very well accepted.

Answer to Question 3: I will explain to the CEO on NPV as below:

Net Present Value is a capital budgeting technique whereby, you would be able to arrive at exact amount of positive present value of the project after the intial investment and acquisition expenditures are met from the cash flows that the project is estimated to generate over a period of time. When a surplus remains after meeting the investment cost, it is considered to be a positive Net Present Value. If the positive NPV is higher, it will produce more profit from the project. If the NPV is negative, it would mean you would not be able to recover the cost of investment from the cash flows generated by the project during its lifespan.

Answer to Question 4:

Advantages of using Payback method:

It is simple and easy to operate.

It helps to take an instantaneous decision.

It can be adopted even by non-financial managers.

It is useful for industries that are suffering from shortage of funds as quick recovery is possible from funds based on payback method.

It is useful for industries that faces uncertainty, instability and technological changes.

It is useful for industries that do not consider profits.

Disadvantages

Time value of money is not considered.  

The profit generated by the project after the payback period is not considered.

A slight change in operation cost will result in distorted workings.

It does not take into consideration depreciation, scrap value and interest factor.

Answer to Question 5: NPV versus IRR

Net Present Value is arrived at after precise working of the cash outflow and cash inflow of the project. Suitable discounting factor is used to discount the future cash inflows. Whereas IRR helps arrive at the Internal Rate of Return of the project. You have to find out if the IRR is above or below your cost of capital. When the IRR is required to be above cost of capital rate, you have to make a reworking to find out the profitability of the project. IRR is an equal stage when the cost and income matches. Whereas NPV will provide an authenticative figure of remainder present value after the cost is met from the future cash inflows.

Answer to Question 6:

Difference between Independent Project and Mutually Exclusive Project:

An independent project is the only one project you are considering to invest in. Whereas, under Mutually Exclusive Project, you have more projects of similar nature that are suitable for investment.  

If it is an independent project, it will be a decision to invest in or not. Whereas, under mutually exclusive projects, you have to find out the NPV of all the projects and choose a particular project if it has a positive and higher NPV than all other projects.

Mutually Exclusive Projects and Conflict:

It is necessary that all the similar projects have strong and dependable estimates of investment cost and cash inflows. Any errors in the operating cost or future cash inflows will throw the capital budgeting techniques out of gear as the NPVs will become erratic. Particularly, if errors are found after the budgeing decision is taken, it will become irreversible and result in loss also.

NPV and IRR based Capital Budgeting:

I would recommend NPV based capital budgeting decision. Because, you have cost of capital and cash inflows details to produce NPV. Whereas, IRR is a technique to find out if the cash inflows match the cash outflows. You will not be able to find out if the project could produce a positive NPV.