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Financial Management: Theory and Practice

Eugene F. Brigham, Michael C. Ehrhardt

Chapter 11

The Basics of Capital Budgeting: Evaluating Cash Flows - all with Video Answers

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Chapter Questions

00:57

Problem 1

A project has an initial cost of $\$ 52,125,$ expected net cash inflows of $\$ 12,000$ per year for 8 years, and a cost of capital of $12 \% .$ What is the project's NPV? (Hint: Begin by constructing a time line.)

Manasvee Singh
Manasvee Singh
Numerade Educator
01:46

Problem 2

Refer to Problem 11-1. What is the project's IRR?

AG
Ankit Gupta
Numerade Educator
01:46

Problem 3

Refer to Problem 11-1. What is the project's MIRR?

AG
Ankit Gupta
Numerade Educator
00:56

Problem 4

Refer to Problem $11-1 .$ What is the project's PI?

Hast Aggarwal
Hast Aggarwal
Numerade Educator
01:46

Problem 5

Refer to Problem $11-1 .$ What is the project's payback period?

AG
Ankit Gupta
Numerade Educator
01:46

Problem 6

Refer to Problem 11-1. What is the project's discounted payback period?

AG
Ankit Gupta
Numerade Educator
03:15

Problem 7

Your division is considering two investment projects, each of which requires an up-front expenditure of $\$ 15$ million. You estimate that the investments will produce the following net cash flows:
$$\begin{array}{ccc}
\text { Year } & \text { Project A } & \text { Project B } \\
\hline 1 & \$ 5,000,000 & \$ 20,000,000 \\
2 & 10,000,000 & 10,000,000 \\
3 & 20,000,000 & 6,000,000
\end{array}$$
What are the two projects' net present values, assuming the cost of capital is $10 \% ?$ $5 \% ? 15 \% ?$

Niamat Khuda
Niamat Khuda
Numerade Educator
02:39

Problem 8

Edelman Engineering is considering including two pieces of equipment, a truck and an overhead pulley system, in this year's capital budget. The projects are independent. The cash outlay for the truck is $\$ 17,100$, and that for the pulley system is $\$ 22,430 .$ The firm's cost of capital is $14 \% .$ After-tax cash flows, including depreciation, are as follows:
$$\begin{array}{ccc}
\text { Year } & \text { Truck } & \text { Pulley } \\
\hline 1 & \$ 5,100 & \$ 7,500 \\
2 & 5,100 & 7,500 \\
3 & 5,100 & 7,500 \\
4 & 5,100 & 7,500 \\
5 & 5,100 & 7,500
\end{array}$$
Calculate the IRR, the NPV, and the MIRR for each project, and indicate the correct accept/reject decision for each.

Vanna Tran
Vanna Tran
Numerade Educator
21:58

Problem 9

Davis Industries must choose between a gas-powered and an electric-powered forklift truck for moving materials in its factory. since both forklifts perform the same function, the firm will choose only one. (They are mutually exclusive investments.) The electric-powered truck will cost more, but it will be less expensive to operate; it will cost $\$ 22,000,$ whereas the gas-powered truck will cost $\$ 17,500 .$ The cost of capital that applies to both investments is $12 \% .$ The life for both types of truck is estimated to be 6 years, during which time the net cash flows for the electric-powered truck will be $\$ 6,290$ per year and those for the gas powered truck will be $\$ 5,000$ per year. Annual net cash flows include depreciation expenses. Calculate the NPV and IRR for each type of truck, and decide which to recommend.

Oluwadamilola Ameobi
Oluwadamilola Ameobi
Numerade Educator
02:02

Problem 10

Project $S$ has a cost of $\$ 10,000$ and is expected to produce benefits (cash flows) of $\$ 3,000$ per year for 5 years. Project $L$ costs $\$ 25,000$ and is expected to produce cash flows of $\$ 7,400$ per year for 5 years. Calculate the two projects' NPVs, IRRs, MIRRs, and PIs, assuming a cost of capital of $12 \% .$ Which project would be selected, assuming they are mutually exclusive, using each ranking method? Which should actually be selected?

Breanna Ollech
Breanna Ollech
Numerade Educator
03:30

Problem 11

Your company is considering two mutually exclusive projects, $X$ and $Y$, whose costs and cash flows are shown below:
$$\begin{array}{ccc}
\text { Year } & \mathrm{X} & \mathrm{Y} \\
\hline 0 & (\$ 1,000) & (\$ 1,000) \\
1 & 100 & 1,000 \\
2 & 300 & 100 \\
3 & 400 & 50 \\
4 & 700 & 50
\end{array}$$
The projects are equally risky, and their cost of capital is $12 \% .$ You must make a recommendation, and you must base it on the modified IRR (MIRR). What is the MIRR of the better project?

Niamat Khuda
Niamat Khuda
Numerade Educator
02:19

Problem 12

After discovering a new gold vein in the Colorado mountains, CTC Mining Corporation must decide whether to mine the deposit. The most cost-effective method of mining gold is sulfuric acid extraction, a process that results in environmental damage. To go ahead with the extraction, CTC must spend $\$ 900,000$ for new mining equipment and pay $\$ 165,000$ for its installation. The gold mined will net the firm an estimated $\$ 350,000$ each year over the 5 -year life of the vein. CTC's cost of capital is $14 \%$. For the purposes of this problem, assume that the cash inflows occur at the end of the year.
a. What are the NPV and IRR of this project?
b. Should this project be undertaken, ignoring environmental concerns?
c. How should environmental effects be considered when evaluating this, or any other, project? How might these effects change your decision in part b?

Kim Trang Nguyen
Kim Trang Nguyen
Numerade Educator
00:00

Problem 13

Cummings Products Company is considering two mutually exclusive investments. The projects' expected net cash flows are as follows:
a. Construct NPV profiles for Projects A and B.
b. What is each project's IRR?
c. If you were told that each project's cost of capital was $10 \%,$ which project should be selected? If the cost of capital was $17 \%$, what would be the proper choice?
d. What is each project's MIRR at a cost of capital of $10 \%$ ? At $17 \%$ ? (Hint:
Consider Period 7 as the end of Project B's life.
e. What is the crossover rate, and what is its significance?

Oluwadamilola Ameobi
Oluwadamilola Ameobi
Numerade Educator
02:39

Problem 14

The Ewert Exploration Company is considering two mutually exclusive plans for extracting oil on property for which it has mineral rights. Both plans call for the expenditure of $\$ 10,000,000$ to drill development wells. Under Plan $A$, all the oil will be extracted in 1 year, producing a cash flow at $t=1$ of $\$ 12,000,000,$ while under $1^{\prime}$ lan $\mathrm{B}$, cash flaws will be $\$ 1,750,000$ per year fur 20 years.
a. What are the annual incremental cash flows that will be available to Ewert Exploration if it undertakes I'lan $\mathrm{B}$ rather than 1 'lan $\mathrm{A}$ ? (Hint: Subtract Plan A's flows from B's.)
b. If the firm accepts Plan $A$, then invests the extra cash generated at the end of Year $1,$ what rate of return (reinvestment rate) would cause the cash flows from reinvestment to equal the cash flows from Plan B?
c. Suppose a company has a cost of capital of $10 \% .$ Is it logical to assume that it would take on all available independent projects (of average risk) with returns greater than $10 \% ?$ Further, if all available projects with returns greater than $10 \%$ have been taken, would this mean that cash flows from past investments would have an opportunity cost of only $10 \%$, because all the firm could do with these cash flows would be to replace money that has a cost of $10 \% ?$ Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project's cash flows?
d. Construct NPV profiles for Plans A and B, identify each project's IRR, and indicate the crossover rate of return.

Nick Johnson
Nick Johnson
Numerade Educator
04:07

Problem 15

The Pinkerton Publishing Company is considering two mutually exclusive expansion plans. Plan A calls for the expenditure of $\$ 50$ million on a large-scale, integrated plant which will provide an expected cash flow stream of $\$ 8$ million per year for 20 years. Plan $\mathrm{B}$ calls for the expenditure of $\$ 15$ million to build a somewhat less efficient, more labor-intensive plant which has an expected cash flow stream of \$3.4 million per year for 20 years. The firm's cost of capital is $10 \%$
The Basics of Capital Budgeting: Evaluating Cash Flows
a. Calculate each project's NPV and IRR.
b. Set up a Project $\Delta$ by showing the cash flows that will exist if the firm goes with the large plant rather than the smaller plant. What are the NPV and the IRR for this Project $\Delta ?$
c. Graph the NPV profiles for Plan A, Plan B, and Project $\Delta$.
d. Give a logical explanation, based on reinvestment rates and opportunity costs, as to why the NPV method is better than the IRR method when the firm's cost of capital is constant at some value such as $10 \%$

Doris Bennett
Doris Bennett
Numerade Educator
02:36

Problem 16

Shao Airlines is considering two alternative planes. Plane A has an expected life of 5 years, will cost $\$ 100$ million, and will produce net cash flows of $\$ 30$ million per year. Plane B has a life of 10 years, will cost $\$ 132$ million, and will produce net cash flows of $\$ 25$ million per year. Shao plans to serve the route for 10 years. Inflation in operating costs, airplane costs, and fares is expected to be zero, and the company's cost of capital is $12 \% .$ By how much would the value of the company increase if it accepted the better project (plane)? What is the equivalent annual annuity for each plane?

Ashima Tiwari
Ashima Tiwari
Numerade Educator
03:02

Problem 17

The Perez Company has the opportunity to invest in one of two mutually exclusive machines that will produce a product it will need for the foreseeable future. Machine A costs $\$ 10$ million but realizes after-tax inflows of $\$ 4$ million per year for 4 years. After 4 years, the machine must be replaced. Machine B costs $\$ 15$ million and realizes after-tax inflows of $\$ 3.5$ million per year for 8 years, after which it must be replaced. Assume that machine prices are not expected to rise because inflation will be offset by cheaper components used in the machines. The cost of capital is $10 \% .$ By how much would the value of the company increase if it accepted the better machine? What is the equivalent annual annuity for each machine?

Hossam Mohamed
Hossam Mohamed
Numerade Educator
02:39

Problem 18

Filkins Fabric Company is considering the replacement of its old, fully depreciated knitting machine. Two new models are available: Machine $1 \%$ -3, which has a cost of $\$ 190,000,$ a 3 -year expected life, and after-tax cash flows (labor savings and depreciation) of $\$ 87,000$ per year; and Machine $360-6,$ which has a cost of $\$ 360,000$ a 6 -year life, and after-tax cash flows of $\$ 98,300$ per year. Knitting machine prices are not expected to rise, because inflation will be offset by cheaper components (microprocessors) used in the machines. Assume that Filkins' cost of capital is $14 \%$ Should the firm replace its old knitting machine, and, if so, which new machine should it use? By how much would the value of the company increase if it accepted the better machine? What is the equivalent annual annuity for each machine?

Vanna Tran
Vanna Tran
Numerade Educator
13:42

Problem 19

The Ulmer Uranium Company is deciding whether or not it should open a strip mine, the net cost of which 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 $\mathrm{r}=8 \% ?$ If $\mathrm{r}=14 \% ?$ Explain your reasoning.
c. Can you think of some other capital budgeting situations where 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 as the NPV method?

Ren Jie Tuieng
Ren Jie Tuieng
Numerade Educator
04:32

Problem 20

The Aubey Coffee Company is evaluating the within-plant distribution system for its new roasting, 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 projects' expected net costs are listed in the table:$$\begin{array}{ccc}
&{\text { Expected Net cost }} \\
\text { Year } & \text { Conveyor } & \text { Forklift } \\
\hline 0 & (\$ 500,000) & (\$ 200,000) \\
1 & (120,000) & (160,000) \\
2 & (120,000) & (160,000) \\
3 & (120,000) & (160,000) \\
4 & (120,000) & (160,000) \\
5 & (20,000) & (160,000)
\end{array}$$
a. What is the IRR of each alternative?
b. What is the present value of costs of each alternative? Which method should be chosen?

Harmender Singh Yadav
Harmender Singh Yadav
Numerade Educator
00:00

Problem 21

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):
$$\begin{array}{ccc}
\text { Year } & \text { Project A } & \text { Project B } \\
\hline 1 & 5 & 20 \\
2 & 10 & 10 \\
3 & 15 & 8 \\
4 & 20 & 6
\end{array}$$
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 capital is $5 \%$, which project should the firm undertake?
e. If the two projects are mutually exclusive and the cost of 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?

Oluwadamilola Ameobi
Oluwadamilola Ameobi
Numerade Educator
06:24

Problem 22

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 $10 \%$
$$\begin{array}{ccc}
\text { Year } & \text { Annual Operating Cash Flow } & \text { Salvage Value } \\
\hline 0 & (\$ 22,500) & \$ 22,500 \\
1 & 6,250 & 17,500 \\
2 & 6,250 & 14,000 \\
3 & 6,250 & 11,000 \\
4 & 6,250 & 5,000 \\
5 & 6,250 & 0
\end{array}$$
a. Should the firm operate the truck until the end of its 5 -year physical life, or, if not, what is its optimal economic life?
b. Would the introduction of salvage values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project?

AG
Ankit Gupta
Numerade Educator
21:58

Problem 23

Start with the partial model in the file $F M 12$ Ch 11 P23 Build a Model.xls from the textbook's Web site. Gardial Fisheries is considering two mutually exclusive investments. The projects' expected net cash flows are as follows:
$$\begin{array}{ccc}
& \text { Expected Net Cash Flows } \\
\text { Year } & \text { Project A } & \text { Project B } \\
\hline 0 & (\$ 375) & (\$ 575) \\
1 & (300) & 190 \\
2 & (200) & 190 \\
3 & (100) & 190 \\
4 & 600 & 190 \\
5 & 600 & 190 \\
6 & 926 & 190 \\
7 & (200) & 0
\end{array}$$
a. If you were told that each project's cost of capital was $12 \%,$ which project should be selected? If the cost of capital was $18 \%$, what would be the proper choice?
b. Construct NPV profiles for Projects A and B.
c. What is each project's IRR?
d. What is the crossover rate, and what is its significance?
e. What is each project's MIRR at a cost of capital of $12 \% ?$ At $\mathrm{r}=18 \% ?$ (Hint:
Consider Period 7 as the end of Project B's life.
f. What is the regular payback period for these two projects?
g. At a cost of capital of $12 \%,$ what is the discounted payback period for these two projects?
h. What is the profitability index for each project if the cost of capital is $12 \% ?$

Oluwadamilola Ameobi
Oluwadamilola Ameobi
Numerade Educator