Basics of Capital Budgeting Evaluating Cash Flows
10-19 (Multiple Rates of Return)
The Ulmer Uranium Company is deciding whether or not to open a strip mine whose net cost is $4.4 million. Net cash inflows are expected to be $27.7 million, all coming at the end of Year 1. The land must be returned to its natural state at a cost of $25 million, payable at the end of Year 2.
A. Plot the project's NPV profile.
B. Should the project be accepted if r= 8%? If r=14%? Explain you reasoning.
C. Can you think of some other capital budgeting situations in which negative cash flows during or at the end of the project's life might lead to multiple IRRs?
D. What is the project's MIRR at r= 8%? At r= 14%? Does the MIRR method lead to the same accept-reject decision at the NPV method?
10-20 (Present Value of Costs)
The Aubey Coffee Company is evaluating the within-plant distribution system for its new roating, grinding, and packing plant. The two alternatives are (1) a conveyor system with a high initial cost but low annual operating costs, and (2) several forklift trucks, which cost less but have considerably higher operating costs. The decision to construct the plant has already been made, and the choice here will have no effect on the overall revenues of the project. The cost of capital for the plant is 8%, and the project's expected net costs are listed in the following table:
|
EXPECTED NET COST
|
|
Year
|
Conveyor (Alternative 1)
|
Forklift (Alternative 2)
|
|
0
|
-$500,000
|
-$200,000
|
|
1
|
-$120,000
|
-$160,000
|
|
2
|
-$120,000
|
-$160,000
|
|
3
|
-$120,000
|
-$160,000
|
|
4
|
-$120,000
|
-$160,000
|
|
5
|
-$20,00
|
-$160,000
|
A. What is the IRR of each alternative?
B. What is the present value of the costs of each alternative? Which method should be chosen?
10-21 (Payback, NPV, and MIRR)
Your division is considering two investment projects, each of which requires an upfront expenditure of $25 million. You estimate that the cost of capital is 10% and that the investments will produce the following after-tax cash flows (In millions of dollars):
|
Year
|
Project A (Millions of Dollars)
|
Project B (Millions of Dollars)
|
|
1
|
5
|
20
|
|
2
|
10
|
10
|
|
3
|
15
|
8
|
|
4
|
20
|
6
|
A. What is the regular payback period for each of the projects?
B. What is the discounted payback period for each of the projects?
C. If the two projects are independent and the cost of capital is 10%, which project or projects should the firm undertake?
D. If the two projects are mutually exclusive and the cost of the capital is 5%, which project should the firm undertake?
E. If the two projects are mutually exclusive and the cost of the capital is 15%, which project should the firm undertake?
F. What is the crossover rate?
G. If the cost of capital is 10%, what is the modified IRR (MIRR) of each project?
10-22 Economic Life
The Scampini Supplies Company recently purchased a new delivery truck. The new truck cost $22,500, and it is expected to generate net after-tax operating cash flows, including depreciation, of $6,250 per year. The truck has a 5-year expected life. The expected salvage values after tax adjustments for the truck are given below. The company's cost of capital is 10%.
|
Year
|
Annual Operating Cash Flow
|
Salvage Value
|
|
0
|
-$22,500
|
$22,500
|
|
1
|
$6,250
|
$17,500
|
|
2
|
$6,250
|
$14,000
|
|
3
|
$6,250
|
$11,000
|
|
4
|
$6,250
|
$5,000
|
|
5
|
$6,250
|
$0
|
A. Should the firm operate the truck until the end of its 5-year physical life? If not, then what is its optimal economic life?
B. Would the introduction to salvage values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project?