Question

You have just arrived at a SnappyPrints Inc., a maker of photo printers.  You are working in the Financial Planning department and have joined a team conducting capital budgeting analysis. Snappy is considering two new projects. Project Mini Printer (PMP) and Project High Speed Printer (HSP).  The WACC is 10%.

You will need to decide which project should be chosen.  Use Ch11 text and slides as a guide.

                                   0                      1                      2                      3

                                   |                      |                      |                      |

Project PMP ($    -150                   40                   75                   100

Project PHS ($)   -150                   65                   75                    85

Answer the following questions:

1.     What is capital budgeting?  Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions?

2.     What is the difference between independent and mutually exclusive projects?  Between projects with normal and non-normal cash flows?

3.     Define the term NPV. What is each project’s NPV? According to NPV, which project(s) should be accepted if they are independent? Mutually exclusive.

4.     How would the NPV’s change if the cost of capital changed?

5.     Define the term IRR. What is the IRR of each project?

6.     What is the logic behind the IRR method?  According to IRR, which project(s) should be accepted if they are independent?  Mutually exclusive?

7.     Calculate and draw NPV profiles for Projects L and S. (Use slides as a guide) Do the NPV profiles cross? If so, what is the crossover rate?

8.     Look at your NPV profile graph without referring to the actual NPVs and IRRs.  Which project(s) should be accepted if they are independent?  Mutually exclusive?  Explain.

9.     What is the underlying cause of ranking conflicts between NPV and IRR?

10.  What is the reinvestment rate assumption, and how does it affect the NPV versus IRR conflict?

11.  Which method is the best?  Why?

12.  Define the term modified IRR (MIRR).  What is the MIRR for each project?

13.  What are the MIRR’s advantages and disadvantages as compared to the NPV?

14.  What is the payback period?  Find the discounted and regular paybacks for the Projects.

15.  What is the difference between the regular and discounted payback methods?

16.  What are the two main disadvantages of discounted payback?  Is the payback method useful in capital budgeting decisions?  Explain.

Upon further analysis, SnappyPrints believes that sales of the new High-Speed Printer would cannibalize the sales of its existing I-Phone Rapid Print Accessory by 50%, resulting in lost annual cash flow of $25.  

17. How can we define/what do we call this effect?
18. Should this effect be included in the cash flow projections?   
19. If so, which project should be accepted?  

Answer 1

1]

Capital budgeting is the process of quantitatively evaluating various investment opportunities, and appraising them with a view to maximize firm value

Yes, there are similarities between a firm’s capital budgeting decisions and an individual’s investment decisions. They both involve estimating cash flows, selecting an appropriate discount rate and calculating the value of each alternative.

2]

Independent projects can be accepted without regard to the accept/reject decision of other projects that are being evaluated.

However, if projects are mutually exclusive, then acceptance of one project necessarily means that the other projects must be rejected.

With normal cash flows, there is a cash outflow in the first period, followed by cash inflows in the subsequent periods. Any cash flow pattern which does not follow this pattern is called a non-normal cash flow

3]

NPV is the value generated for the firm's investors. It is the sum of the present values of a project's cash flows.

If projects are independent, the project should be accepted if the NPV is positive.

If projects are mutually exclusive, the project with the highest non-negative NPV should be accepted.

NPV is calculated using NPV function in Excel

4]

NPV and cost of capital are inversely related. Higher the cost of capital, lower the NPV and lower the cost of capital, higher the NPV.