Question

Create your own hypothetical capital budgeting project.

Make up a company (it could be real or fictional) and make up/describe a potential project for that company (you should be able to do this in one or two sentences…don’t worry about extreme detail).

1.Create a cash flow stream for this project (the cash flow stream should be between 4-7 years in length), a critical acceptance level (T), and a required return (k). (Hint: Your cash flows must exceed your initial investment and your critical acceptance level must be less than the length of the project).

2. Calculate the PP, IRR, and NPV for your project

3.For each decision technique, identify whether or not that technique suggests you should accept or reject the project

Overall, identify whether or not you should accept or reject the project and why. Note that part D is asking for 3 answers (one for each decision technique) while E is just asking for one answer – what is your final recommendation. Also, why doesn’t need to be a long answer, just a few words.

Answer 1

We’ll consider a fictional company called Fancy Foods. They are considering investing in a new restaurant facility in an upmarket area. The Project is proposed for 5 years post which the company will exit. Initial investment is 200,000 dollars. Of this, the necessary equipment will cost $150,000 that can be depreciated on a straight-line basis over the five years. The salvage value = 0

The company expects to generate $110,000 per year as revenue and operating costs are assumed to be 55,000 dollars per year. All revenues and expenses are in real terms so inflation is not to be considered. The Company’s marginal tax rate is 20%. The required return on the investment is 10%

We have the following cash flows:

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Investment Outlay	-200000
Income		110000	110000	110000	110000	110000
Depreciation		30000	30000	30000	30000	30000
Operating Expense		55000	55000	55000	55000	55000
Pre Tax Income		25000	25000	25000	25000	25000
Tax		5000	5000	5000	5000	5000
Post Tax Income		20000	20000	20000	20000	20000
Add back: Depreciation		30000	30000	30000	30000	30000
Total Operating Cash flow	-200000	50000	50000	50000	50000	50000
		NPV	IRR
		-£9,509.69	7.931%

Using the cash flows in the table above, we can calculate the NPV, IRR, and the Payback period for the project.

We have NPV using 10% = -9509.69

IRR = 7.93%

NPV: Reject. Because NPV is negative here

IRR: Reject because IRR is less than the required return of 10%

Payback Period = amount of time it takes to recover the initial investment, without considering any time value of money. We can see that initial investment was 200,000 and after 4 years, a total of 200,000 in positive cash flows is recovered by the company. Thus, using the Payback period as the criterion, the project can be accepted.