Question

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. Compute each project’s IRR, NPV, payback, MIRR, and discounted payback.  
3. Which project(s) should be accepted if they are mutually exclusive? Explain  
4. Which project(s) should be accepted if they are independent? Explain

Answer 1

1. WACC=(weight of debt*after tax cost of debt)+(weight of equity*cost of equity)

after tax cost of debt=interest rate*(1-tax rate)=10%*(1-50%)=5%

cost of equity=(next year dividend/Share price)+growth rate=(2/20)+8%=10%+8%=18%

WACC=(50%*5%)+(50%*18%)=2.5%+9%=11.5%

2. Use IRR function in EXCEL for IRR

=IRR(Year0 to Year4 cashflows)

use NPV function for NPV

=NPV(rate,Year1 to year4 cashflows)-Year0 cashflow

=NPV(11.5%,Year1 to year4 cashflows)-10,000

For MIRR, use MIRR function

=MIRR(Year0 to year4 cashflows,finance rate,reinvest rate)

=MIRR(Year0 to year4 cashflows,11.5%,11.5%)

WACC	11.50%
Time	Cashflows North zone	Cashflows East zone
0	-10000	-10000
1	6500	3500
2	3000	3500
3	3000	3500
4	1000	3500
IRR	18%	15%
NPV	1053.87	743.65
MIRR	14.3%	13.5%

==>Payback period is time it takes to retain the cost of investment

Project Northzone=It takes 2 years to receive 9500 and 500 in 3rd year.

3rd year=500/3000=0.17

Payback period=2.17 years

Project Eastzone= It takes 2 years to receive 7000 and 3000 in 3rd year.

3rd year=3000/3500=0.86

Payback period=2.86 years

==>For disconted cashflows, we have to use discounted cashflows at 11.5%

Project Northzone, discounted payback period= It takes 2 years to receive 8242.68 and 1757.32 in 3rd year.

3rd year=1757.32/2164.2=0.81

Discounted Payback period=2.81 years

Project Eastzone= It takes 3 years to receive 8479.17 and 1520.83 in 4th year.

4th year=1520.83/2264.48=0.67

Disconted Payback period=3.67 years

WACC	11.50%
Time	Cashflows North zone	Discounted cashflows	Cashflows East zone	Discounted cashflows
0	-10000	-10000	-10000	-10000
1	6500	5829.60	3500	3139.01
2	3000	2413.08	3500	2815.26
3	3000	2164.20	3500	2524.90
4	1000	646.99	3500	2264.48

3. If mutually exclusive projects, only one project should be accepted. Here NorthZone Project has be selcted because all the capital budgeting techniques are better like NPV, IRR and MIRR are higher and Payback period is lower for North zone than the East zone.

4. If the projects are independent, both the projects are to be selected because of NPV is positiive, both IRR and MIRR > WACC. Both teeh projects increases the shareholder's wealth.