EPPP Report-

7/29/2019 EPPP Report-

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Erget Printing and Publishing PressCase: Capital Budgeting

Corporate Financial Decision

Submitted to:

Prof. Dr. Radhe S. Pradhan, Ph.D.

Ace Institute of Management

New Baneshwor

Submitted by:

Sachindra Pradhanga

Sagar Nath Upadhyaya

Serish Dhital

Sudeep Bir Tuladhar

Sushil Bajimaya

Chandika Amgain

EMBA, Fall 2011


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Contents

Background ..................................................................................................................................... 1

Projects ........................................................................................................................................ 1

Project A: Major Plant Expansion .......................................................................................... 1

Project B: Alternative Plan for Plant Expansion..................................................................... 1

Project C: Purchase of New Press ........................................................................................... 2

Project D: Upgrade of Egrets Video Text Service ................................................................ 2

Question 1 ....................................................................................................................................... 3

Payback, NPV, IRR Determination ........................................................................................ 3

Project Ranking ....................................................................................................................... 3

Project Selection ..................................................................................................................... 4

Appropriate Discount Rate ..................................................................................................... 4

Question 2 ....................................................................................................................................... 7

Calculation of Equivalent Annual Annuity (EAA) for each project ....................................... 8

Question 3 ..................................................................................................................................... 10

Question 4 ..................................................................................................................................... 13

Question 5 ..................................................................................................................................... 20

Question 6 ..................................................................................................................................... 22

Question 7 ..................................................................................................................................... 24

Question 8 ..................................................................................................................................... 27

Question 9 ..................................................................................................................................... 29

Question 10 ................................................................................................................................... 31

Annex ............................................................................................................................................ 32

Calculation of Payback Period .................................................................................................. 32

Project A ............................................................................................................................... 32


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Project B................................................................................................................................ 32

Project C................................................................................................................................ 32

Project D ............................................................................................................................... 33

Discounted Payback Period for Project A ............................................................................ 33

Project B................................................................................................................................ 34

Project D ............................................................................................................................... 35

Net Present Value ..................................................................................................................... 36

IRR (Internal Rate of Return) ................................................................................................... 36

Project B................................................................................................................................ 36

Project C................................................................................................................................ 37

Project D ............................................................................................................................... 37


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Background

Egret Printing and Publishing Company is a family owned speciality printing business founded

by John and Keith Belford in 1956 after they were retired from the US Army. Patrick Hill, Keith

Belfords son in law, joined the firm in 1979 in the Accounting Department and was promoted as

a treasurer in 1988 and then as the Vice-President of Finance in 1994. Hill has the responsibility

for both external and internal financial operations, but mostly it is internal. John and Keith

Belford were reluctant about long term debt financing their business because they were aware of

the difficulties their father faced during the Great Depression. However, Hill doesnt agree with

this philosophy and feels that all equity capital structure is conservative.

The term capital budgeting refers to the process of decision making by which firms evaluate the

purchase of major fixed assets, including building, machineries, and equipment. Capital

budgeting describes the firms formal planning process for the acquisition and investment of

capital and results in capital budget that is the firms formal plan for the expenditure of money to

purchase new fixed asset for expansion or replacement of business.

Hill is presently occupied with detailed analysis of four major capital investment proposals that

the Belfords have identified as possible candidates for funding in the coming year. A description

of each of the four projects is also given that includes information such as the costs and expected

after-tax cash flows (net income plus depreciation). The four projects are considered to be

equally risky and their risk is about the same as that of the companys other assets.

Projects

Project A: Major Plant Expansion

This project is designed to alleviate the capacity problem by constructing a new wing on the

main plant. This additional space would allow to hold a greater variety of paper stock in

inventory and to reposition its various processes for a more efficient work flow.

Project B: Alternative Plan for Plant Expansion

This project is an alternative of project A. It can be installed much more quickly and will allow

Egret to take several major printing jobs in the next few years.


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Project C: Purchase of New Press

This is a dependence project on A or B. So, the existence of this project will not affect the future

cash flow for project A or B. It is basically for covering the extra market of high quality color

calendar demanders.

Project D: Upgrade of Egrets Video Text Service

This is independent project toward video test service in which the firm has made investment

since 1991 and because the number of existing as well as new subscribers has fallen, it is

inherent to invest in this project.


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Question 1

Determine the Payback, net present value and the internal rate of return for each project,

using both 15 and 21 percent discount rates; rank the investment proposals considering the

capital budget of $ 1.5 million. Which projects should the company choose and why? (Note:Projects A and B are mutually exclusive).Payback, NPV, IRR Determination

Payback period, Net Present Value and Internal rate of return for all four projects are as follows:

Projects PP DPP@15% DPP@21% NPV@15%($) NPV@21%($) IRR

A 3.148675 3.530375 3.755012 166,167.40 70,720.60 26.62227

B 1.481481 1.857931 2.1122 159,447.70 100,534.00 34.99251

C 3.0959 1.881595 2.068357 625,400.60 309,409.7 29.94826

D 2.8571 3.980313 4.678977 141,480.00 12,032.50 22.10892

Project Ranking

Rank NPV@15%

1 C

2 A

3 B

4 D

For detailed calculations, please refer the annex.

The projects are ranked on the basis of their NPV values. NPV is for ranking the projects

because of the following reasons:

It takes into account all cash flows. All cash flows are discounted at the appropriate market-determined opportunity cost of

capital.

NPV of a project is exactly the same as the increase in shareholders wealth as can beseen from below:

Pay off all interest payments to creditors.


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Pay off all expected returns to shareholders. Pay off the original investment.

Project Selection

Project Combination Required Investment NPV@15% Rank NPV@ 21% Rank

A and C 1,500,000 $791,568.00 1 $380,130.3 2

B and C 1,500,000 $784.848.3 2 $409,943.7 1

C and D 1,500,000 $766.880.6 3 $321,442.2 3

A and D 1,000,000 $307.647.4 4 $82,753.1 5

B and D 1,000,000 $300.927.7 5 $112,566.5 4

If the discount rate is 15%, then the company should choose the combination of projects A and

C. If the discount rate is 21%, then company should choose the combination of projects B and C.

The NPV of combination give highest value compared to others. The combination C and D is not

feasible because project C cannot be implemented if both projects A and B are rejected.

Appropriate Discount Rate

Since the net present value at 15% discount rate is higher than that of 21%, 15% is more

appropriate percentage for discounting.

Comparison of Different Projects

Payback period, discounted payback period, net present values and internal rates of return for all

of the projects are compared with each other in the following graphs.


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Figure 1: Comparison of NPV of different projects

Figure 2: Comparison of payback period


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Figure 3: Comparison of IRR of all the projects

0

5

10

15

20

25

30

35

40

IRR

Project A

Project B

Project C

Project D


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Question 2

Do you find anything wrong in choosing the projects based on payback, NPV and IRR as

stated above? What suggestions can be made to the company? How should the projects

with unequal lives be dealt with? Determine the equivalent annual annuity (EAA) for eachproject and based on the calculations, which projects should Egret Printing and Publishing

Company accept for the coming year and why?

Payback Period is the number of years required to recover the initial capital expenditure on a

project. Payback period is also the ratio of Original Investment to Annual cash flow having

condition, if cash are equal or even. Since payback period is easy to calculate it is being widely

used. But it has some limitations like: It does not consider time value of money; it is not capable

to measure profitability, Ignores cash flows occurring after the payback period. Due to some of

these limitations the firm cannot fully rely on this method only for choosing among the projects.

Net Present Value (NPV) requires finding the present value of the expected net cash flows of an

investment, discounted at the cost of capital, and subtracting from it the initial cost outlay of the

project. NPV is considered feasible only if the firm knows the cost of capital or discounted

factor, which may not be the current cost existing in the market. NPV is a useful starting point to

value investments, but certainly not a definitive answer that an investor can rely on for all

investment decisions.

Internal Rate of Return (IRR) is the interest rate that equates the present value of the expected

future cash flows, or receipts, to the initial cost outlay. If IRR is greater than cost of capital we

accept the project else we reject it. The main drawback of IRR is, it is difficult to understand as

there may be two experimental rates because of unequal present value of cash inflow with

present value of cash outflow; it is not helpful for comparing two mutually exclusive investments

and comparing two projects.

Project choice based on Payback, NPV and IRR are not always consistent. They may give

different indications about the projects financial characteristics. Moreover the decision on

different age of projects cant be sufficed by calculating NPV without taking consideration of

project life. The reason for this potential problem is the timing of the cash flows of the mutually


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exclusive projects. As a result, there is a need to adjust for the timing issue in order to correct

this problem.

Project with unequal lives can be dealt with two methods they are:

1. Replacement-chain method: In this approach the projects under the evaluation are madeby making the lives of the project common or equal lives.

2. Equivalent annual annuity: in this approach the constant annual annuity is calculated forthe projects that has the same NPV as that calculated in the projects.

The company can be suggested to calculate the Equivalent Annual Annuity (EAA) by

eliminating the effect of the life of the project. EAA will give the average annual return that each

project will provide. So comparing the same annual return is realistic. The project having the

highest EAA should be chosen as higher EAA is associated with higher NPV. But we should

equally take care on whether the given annual return can be replicated by short life projects in

the same way.

Calculation of Equivalent Annual Annuity (EAA) for each project

Project Years NPV@15%PMT=

NPV/PVIFA15%,4years

NPV @ 21%

PMT=NPV/PVIFA21%, 4years

A 4 164,577.60 57,645.39 71,043.60 27,969.92

B 4 156,038.00 54,654.29 100,488.00 39,562.20

C 10 621,137.00 122,006.87 310,088.00 76,489.39

D 5 86,775.00 25,887.53 2,225.00 4,178.06

Particulars Project A Project B Project C Project D

EAA @15% 57645.39 54654.29 122006.87 25887.53

EAA @21% 27969.92 39562.2 76489.39 4178.06
mailto:NPV@15%25mailto:NPV@15%25mailto:NPV@15%25


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ProjectCombination

EAA @ 15% Rank EAA at 21% Rank

A and C $179,652.26 1 $104,459.31 2

B and C $176,661.16 2 $116,051.59 1C and D $147,894.40 3 $80,667.45 3

A and D $83,532.92 4 $32,147.98 5

B and D $80,541.82 5 $43,740.26 4

Hence from the above calculation we can conclude that: at 15% A and Cs combination is the

best and at 21% B and Cs combination is the best as both combination has highest EAA

achieved.


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Question 3

Draw the graph of NPV versus discount rate for projects A and B (a present value profile)

using, in part, your answers for the IRR and NPV in Question 1. Also determine the

crossover rate by following the computational procedure. Which Project appears to besuperior? Why?

Calculation for the Graph

Project A

ProjectA

PVIF@0%

PV@ 0%

PVIF@

10%PV

@ 10%

PVIF@

20%PV

@ 20%PVIF

@ 30%PV

@30%

PVIF@

40%PV40

-500,000 1 -500,000 1 -500,000 1 -500,000 1 -500,000 1 -500

136,000 1 136,000 0.909 123,624 0.833 113,288 0.769 104,584 0.714 97,1

136,000 1 136,000 0.826 112,336 0.694 94,384 0.592 80,512 0.51 69,3

136,000 1 136,000 0.751 102,136 0.579 78,744 0.455 61,880 0.364 49,5

618,800 1 618,800 0.683 422,640.4 0.482 298,261.6 0.35 216,580 0.26 160

526,800 260,736.4 84677.6 -36,444 -123

Project B

ProjectB

PVIF@0%

PV @0%

PVIF@

10%PV @10%

PVIF@

20%PV @20%

PVIF@

30%PV

@30%

PVIF@

40%PV40

-500,000 1 -500,000 1 -500,000 1 -500,000 1 -500,000 1 -50

370,000 1 370,000 0.909 336,330 0.833 308,210 0.769 284,530 0.714 26

270,000 1 270,000 0.826 223,020 0.694 187,380 0.592 159,840 0.51 13

155,000 1 155,000 0.751 116,405 0.579 89,745 0.455 70,525 0.364 5

49,000 1 49,000 0.683 33,467 0.482 23,618 0.35 17,150 0.26 1

344,000 209,222 108,953 32,045 -2

Calculation of Crossover rate

Year project A(CF)

Project B(CF)

Diff.(CF)

PVIF@16%

PV PVIF@17%

PV

0 -500000 -500000 0 1 0 1 0

1 136000 370000 234000 -0.862 -201708 0.8547 -199999.8

2 136000 270000 -134000 0.7431 -99575.4 0.7305 -97887


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3 136000 155000 -19000 0.6407 -12173.3 0.6243 -11861.7

4 618800 49000 569800 0.5523 314700.54

0.5336 304045.28

1243.84 -5703.22

The crossover chart shows the crossover rate is 16.17 %. It means both the project have same

NPV i.e. 144320 at this rate. Strictly from quantitative view, below the crossover rate, Project A

is better whereas above the crossover rate, Project B is better in terms of NPV. The relative

stability of NPV of project B over project A may be added factor that will provide us qualitative

reason to choose project B at some rate below crossover rate. Not only this, Project B is

relatively stable. It is because the significant portion of cash inflow of project B occurs at the

beginning years whereas the highest cash flow of project A occurs at the end of year 4. Therefore

the fluctuation on WACC will also have less impact on the Project B whereas project A is highly

sensitive. IRR also supports project B but IRR is not a sole determinant in the decision to select

project B and it is NPV that matters most.

In this case, Project B is our obvious choice because the required rate is 21 % which is above

crossover rate where NPV is higher for project B than project A. The conflict only arises in


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choosing project if the required rate drops below crossover rate. In that case we may choose

project A if there is certainty that the required rate will not cross the crossover rate significantly

during the project life. Otherwise project B is best.


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Question 4

Now suppose that Hill made a mistake in the projected cash flows for Project D they

should have been $195,000 per year. Determine the effect of this change would have on

capital budgeting. Would this situation bear on the decision about the mutually exclusiveprojects? Explain.

Project D

After correction in Cash Flows

a) Ordinary Payback PeriodCash Flows Cumulative Cash Flows

Original Investment -500,000 -500,000

Year 1 195,000 -305,000

Year 2 195,000 -110,000

Year 3 195,000 85,000

Year 4 195,000 200,000

Year 5 195,000 375,000

Payback Period = (500,000/195,000)

= 2.56 years

b) Discounted Payback PeriodProject D @ 15% discount rate:

Year Cash Flows PVIF@15% PV Cumulative CFs

0 -500,000 1 -500,000 -500,000

1 195,000 0.87 169,650 -330,350

2 195,000 0.756 147,420 -182,930

3 195,000 0.658 128,310 -54,620

4 195,000 0.572 111,540 56,9205 195,000 0.497 96,915 153,835

NPV 153,835


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Discounted Payback Period = 3 + (54,620/111,540)

= 3.48 years

Project D @ 21% discount rate:


0 -500,000 1 -500,000 -500,000

1 195,000 0.826 161,070 -338,930

2 195,000 0.683 133,185 -205,745

3 195,000 0.565 110,175 -95,570

4 195,000 0.467 91,065 -4,505

5 195,000 0.386 75,270 70,765NPV 70,765

Discounted Payback Period = 4 + (4,505/75,270)

= 4.05 years


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c) IRR

Year CFs PVIF @ 27% PV Cumulative CFs

0 -500,000 1 -500,000 -500,000

1 195,000 0.787 153,465 -346,5352 195,000 0.62 120,900 -225,635

3 195,000 0.488 95,160 -130,475

4 195,000 0.384 74,880 -55,595

5 195,000 0.303 59,085 3,490

NPV 3,490

Year CFs PVIF @ 28% PV Cumulative CFs

0 -500,000 1 -500,000 -500,000

1 195,000 0.781 152,295 -347,7052 195,000 0.61 118,950 -228,755

3 195,000 0.477 93,015 -135,740

4 195,000 0.373 72,735 -63,005

5 195,000 0.291 56,745 -6,260

NPV -6,260

IRR = Lower Rate + {NPV of LR / (NPV of LR - NPV of HR)}* (HRLR)

= 27% + {3,490/ (3,490+6260)}* (28-27)

= 27% + 0.36 = 27.36

Changes on Project D, after correction in cash flows

Criterion

Project D (cashflow of Rs.175,000

each year)

Project D (cash flowof Rs. 195,000 each

year) Changes ResultOrdinaryPaybackperiod 2.86 2.56 0.3

Decrease inpayback period

NPV @ 15 % 86,775 153,835 -67,060.00

Increase in NPVNPV @ 21% 12,225 70,765 -58,540.00

IRR 22.11 27.36 -5.25 Increase in IRRDiscountedpayback period

@ 15%4.02 3.48 0.54

Decrease indiscounted paybackDiscounted

payback period@ 21%

4.82 4.05 0.77


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Comparison of Different Projects

Year Project A Project B Project C Project D

0 -500,000.00 -500000 -1,000,000.00 -500,000.00

1 136,000.00 370000 323,000.00 195,000.002 136,000.00 270000 323,000.00 195,000.00

3 136,000.00 155000 323,000.00 195,000.00

4 618,800.00 49000 323,000.00 195,000.00

5 323,000.00 195,000.00

6 323,000.00

7 323,000.00

8 323,000.00

9 323,000.00

10 323,000.00NPV @ 15% $164,577.60 $156,038 $621,137 $153,835

NPV @ 21% $71,043.60 $100,488 $310,088 $70,765

IRR 26.61% 35.02% 29.94% 27.36%

Payback period 3.15 years 1.48 years 3.1 years 2.56 years

Discounted paybackperiod @ 15% 3.54 years 1.87 years 4.48 years 3.48 years

Discounted paybackperiod @ 21% 3.75 years 2.11 years 5.53 years 4.05 years

Above calculation shows that NPV of Project D increased from $86,775 to $153,835 when

the annual cash flow changed from $175,000 to $195,000 when the discount rate is 15%. When

the discount rate is 21%, the NPV of this project increased from $12,050 to $70,570. Similarly,

the IRR of the project has also increased from 22.16% to 27.46%. With the changed cash flow of

Project D, the payback periods at both discounting rates of 15% and 21% have also decreased

slightly.

The calculation of NPV, IRR and payback periods all imply that Project D is feasible. However,

due to the constraints of the capital budget, the selection of Project D cannot be considered since

Project A and Project C has been recommended which adds up to the available budget of $1.5

million. In order to select Project D, the company would have to acquire a long-term debt of

$500,000. The new debt of $500,000 for Project D, however, would not make any difference to

the mutually exclusive projects.


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Changes on Project D, after correction in class flows

Comparison of Payback Period (years), IRR (%) and Discounted payback period at different

rates of Project D, after changes in Cash Flows

Comparison of NPV at different rates of Project D, after changes in Cash Flows

-

5.00

10.00

15.00

20.00

25.00

30.00

Payback IRR Discounted

payback period

@ 15%

Discounted

payback period

@ 21%

Project D (cash flow of

Rs.175,000 each year)

Project D (cash flow of Rs.

195,000 each year)

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180,000

NPV @ 15 % NPV @ 21%

Project D (cash flow of

Rs.175,000 each year)

Project D (cash flow of Rs.

195,000 each year)


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Comparison of Different Projects(after change in Cash Flows of Project D)

Comparison of NPV at different rates of all the projects, before and after changes in Cash Flows

of Project D

Comparison of IRR of all the projects, before and after changes in Cash Flows of Project D

0

100000

200000

300000

400000

500000

600000

700000

NPV @ 15% NPV @ 21%

Project A

Project B

Project C

Project D (Rs. 195,000)


0

5

10

15

20

25

30

35

40

IRR

Project A

Project B

Project C




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Comparison of Different Projects(after change in Cash Flows of Project D)

Comparison of Payback period and discounted payback period at different rates of all the

projects, before and after changes in Cash Flows of Project D

0

1

2

3

4

5

6

Payback period Discounted paybackperiod @ 15%

Discounted paybackperiod @ 21%

Project A

Project B

Project C




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Question 5

Assuming that the return on Project A is representative of the investment opportunitities

generally found on the printing industry, would it be reasonable for Hill to claim that

project B will generate a return of approximately 35 percent over its four year life?Explain in terms of available reinvestment rates.

We Know that the Internal Rate of Return (IRR) is the discounting factor that makes the NPV of

the project zero. In this case the IRR of project A is approximately 27%. Since project As IRR is

equal to reinvestment rate, reinvestment rate would be 27% as well. Similarly, the IRR of project

B is 35%. Hence the representative of investment opportunities for printing industry is only 27%

which is much lower than 35% it would not be reasonable to claim that Project B will generate a

return of approximately 35% over four year life.

Calculation of MIRR:

For Project B

Year Cash Inflows FVIF @ 27% FV of Inflows

1 $370,000.00 2.0483 $757,871.00

2 $270,000.00 1.6129 $435,483.00

3 $155,000.00 1.27 $196,850.00

4 $49,000.00 1 $49,000.00

Terminal Value of Cash Inflows $1,439,204.00

MIRR is calculated to determine the rate at which the present value of a projects outflow equals

the terminal value of the projects inflows. Trying at 35% and 25%, we get

PVIF @35%

PV @ 35% PVIF @ 25% PV@ 25%

Present Value of

Terminal Cash Inflow

$1,439,204 0.3011 $433,344.32 0.4096 $589,497.96

Present Value ofOutflow

$500,000 1 $500,000 1 $500,000

NPV ($66,655.68) $89,497.96

MIRR= 25% + 89,497.96/ (89497.96+66,655.68) * (35-25)


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= 30.73%

As we can see in the above calculation, MIRR of the project B is 30.73% at reinvestment rate of

around 27%. Therefore, it can be concluded that for reinvestment of around 27%, project B will

generate return around 30.73%


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Question 6

If Hill is confident that he will be a ble to generate more and better projects in the years to

come, but relatively doubtful that he will be able to persuade the Belford brothers to

employ debt financing, how might this influence his recommendation. Could there ever bea situaltion in which project D is advisable? Explain.

Egret Printing and Publishing Company has stuck to an extremely conservative approach of

capital structure by adapting all equity capital. The cost of equity capital is 15% for the capital

budget of $1.5 million. The company is reluctant to modify its financing style due to some bad

experience in the past. But the company should be open to change if the facts and figures are in

favour. So if debt financing generates higher returns then the company should be open to it as

well.

Patrick Hill has done his homework. He has discussed with the bank about debt financing and

has got an assurance of $500,000 at the rate of 12%. From the discussions with Belfords, Hill has

come to a conclusion that their opportunity cost on outside investments is 21%. Funds over and

above the $1.5million that will be generated internally are available, but the marginal cost of this

extra capital is 21% rather than 15% cost of internal funds. Though Belford brothers have

resisted the attempts to convince them to use debt, they are always willing to listen to new

arguments on the subject.

If Belford Brothers are convinced to opt for a debt financing of $500,000 then the total capital of

the company will increase from $1.5million to $2million.

Then the new capital structure will be:

Type of capital Amount ($) Weight After tax cost WeightedCost

Long term debt 500,000 0.25 6.48% 1.62%

Preferred stock 0 0 0 0

Common equity 1,500,000 0.75 15% 11.25%

Weighted average cost of capital 12.87%

Calculation of kdt:

Interest rate of debt (kd) = 12%


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After tax cost of debt (kdt) = kd*(1-tax rate) = 12*(1-0.46) = 6.48%

Where,

Weight of debt = 500,000 /2,000,000 =0.25

Weight of equity= 1500,000 /2,000,000= 0.75

This shows that the weighted average cost of capital has decreased from 15% to 12.87%. Also

the increase in capital will allow the company to undertake an additional project. Projects A and

Project B are purposed as alternatives and we have recommended one of them so the next option

is project D with a total investment of $500,000. So project D is advisable in this scenario.


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Question 7

If the Belfords agree to Hills proposal to use a modest amount of debt to finance the

projects this year, what would be its implication on the present capital structure and the

cost of capital? In terms of the future returns to the Belfords families, what would be theimpactfrom using this debt financing or what would be the extra value addition in the

present values of the selected projects? (Revise your computations using a new discount

rate and conclude about the projects to be chosen.)

If Belfords agree to Hills proposal to use debt financing, they will use $500,000 debt at 12%

interest rate. So, the company has now, $ 2 million to invest in the projects and can choose three

projects. From the investment of 2,000,000 we can select three projects, we can choose either (A,

C & D) or (B, C & D) since Project A and Project B are presented as alternatives in the case.

Calculation of the new cost of capital with their respective financial source weights is already

shown in the previous section. This gave the weighted average cost of capital to be 12.87%.

Now,

Yr.PVIF

@12.87Cash

Flow(A)Cash

Flow(B)Cash

Flow(C)Cash

Flow(D) PV(A) PV(B) PV(C) PV(D)

0 1 -500,000-

500,000 -1,000,000 -500,000 -500,000 -500,000 -1,000,000 -500,0

1 0.886 136,000 370,000 323,000 175,000 120,496 327,810.756 286,169.93 155,045.6

2 0.785 136,000 270,000 323,000 175,000 106,760 211,936.967 253,539.408 137,366.5

3 0.695 136,000 155,000 323,000 175,000 945,74.4 107,794.381 224,629.581 121,703.3

4 0.616 618,800 49,000 323,000 175,000 381,242.68 301,91.3116 199,016.197 107,826.1

5 0.546 323,000 175,000 176,323.378 955,31.24

6 0.484 323,000 156,218.107

7 0.428 323,000 138,405.34

8 0.38 323,000 122,623.673

9 0.336 323,000 108,641.511

10 0.298 323,000 96,253.6643

TPV of Inflows 703,073.08 677,733.415 1,761,820 617,472.8

NPV 203,073.08 177,733.415 761,820.79 117,472.8


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Net present value of project A, C & D = NPV of Projects (A + C +D)

= $(203,073.08+ 761,820.79+ 117,472.868)

=$ 1,082,366.738

Net present value of project B, C & D = NPV of Projects (B + C +D)

= $(177733.415+ 761820.79+ 117472.868)

=$ 1,057,027.073

Profitability Index of Projects:

Discount rateCombination

of ProjectsInitial

Investment NPV PV of InflowProfitability

Index(PI)

12.87% A, C & D 2 million 1,082,366.74 3,082,366.74 1.54

12.87% B, C & D 2 million 1,057,027.07 3,057,027.07 1.52

From this table we can select projects A, C and D when the company takes the debt financing

with 12.87% cost of capital. When 15% cost of capital was taken as discounting factor, the

combined NPV of project A& C reveals higher value. So, this was selected as the best

combination. Also, there was internal financing through retained earnings and excluded external

financing through debt.

With all Equity financing at 15% cost of Capital:

Net present value of project A & C = NPV of Projects (A + C)

= $(166,167.40+625,400.60)

=$791,568.00

The impact of using this debt financing is shown by the extra value addition in present values of

selected project:

Particulars Amount

Net present value of selected projects after inclusion of debt in capital structure $1,082,366.74

Less: Net present value of selected projects before inclusion of debt in capitalstructure.

$791,568

Extra value additional due to use of debt financing $290,798.74


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This shows that when debt financing is used the company can yield more NPV as debt financing

helps to leverage the capital structure. Debt financing is relatively cheaper financing method as

the company can utilize capital with lower rate. Therefore, instead of using the combination of

projects A & C, the combination of A, C & D should be selected considering the profitability

index which is calculated on the basis of NPV and Total PV of inflows.


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Question 8

Assuming that the $1.5 million of internal funds available to finance new investment is

after paying a dividend of $300,000 and represents an average addition to retained

earnings, do you consider the use of $500,000 of debt to increase the risk to the Belfords byvery much? Explain by considering times interest earned ratio.

Calculation of Net Profit:

Particulars Amount

Dividend 300,000

Retained Earning 1,500,000Net Profit 1,800,000

Calculation of EBIT:

Particulars Amount

EBIT 3,393,333.33

Less: Interest 60,000

EBT 3,333,333.33

Less: Tax @ 46% 1,533,333.33

Net Profit 1,800,000

Thus it is seen that the internal funds of $1.5 million after paying a dividend of $300,000 will

yield interest earned ration of 56.55 with use of $500,000 of debt. This represents a very healthy

ratio. The reason behind this high interest earned ratio is low amount of debt capital used by the


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company and only a small portion of EBIT will be required to pay the interest expense. Hence it

is clear that the use of $500,000 of debt will not increase the risk to the Belfords very much.


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Question 9

The case stated that Project C would be feasible unless either Project A or Project B was

also accepted. What is the implication of this statement on the current capital budgeting

analysis? Do you think that the way Project C is handled earlier in the case valid? Why orwhy not?

As mentioned in the case, projects A and B are mutually exclusive so that either of this project

can be chosen at one particular time whereas project C cannot be feasible unless projects A or B

is accepted. Basically projects A and B are related to alleviating capacity problem by expansion

of the plant where as project C is related to purchase of new printing equipment and press. Once

the new equipment and press is bought, it will require additional space to function. So project A

and B provides the basis required for project C to be implemented. Therefore the feasibility of

project C is very much dependent on acceptance of either project A or project B.

Moreover, project C does not have any side effect on viability and profitability of project A and

project B. Hence, project A and B are independent upon C whereas project C is dependent on

either of them.

Another implication is that a project combination of C and D could never be used. Although a

project combination of C and D requires $1,500,000, however, for C to be implemented, further

$500,000 needs to be invested in either Project A or B. This would take the total investment to

$2 million which requires debt and the firm is not in a position to use the debt capital.

The way project C is handled is not very logical we already know that project C is dependent on

acceptance of project A or B. It will be very convenient and logical if we can take dependent

projects as a single alternative and deal as a joint project like projects A & C and projects B& C

should have been treated as single projects. Hence the number of options to rank should have

been 5 and they are: project A, project B, project A&C, project B&C and project D. The cash

flow and project outlay of the joint projects also should have been combined. Due to its

dependency, project C has reduced the alternatives. It has made the combination of project C and

project D as unfeasible alternative.

Moreover, the ranking of the projects also has been affected by the dependency of project C. Had

there not been any dependent project among the alternatives, all the projects could have been


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ranked solely based on their merits. However, in our case we are compelled to consider

dependency condition first and then only other ranking parameters which will not lead us to the

optimum result. So dependent projects should be treated as single projects as explained above.


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Question 10

Do you think that the quantitative measures alone are important in capital budgeting

evaluation? What qualitative factors could also be important in capital budgeting

evaluation?

The main objective of any firm is to increase the shareholders wealth and maximize the profits

for the firm. With the quantitative measures of capital budgeting evaluation, the firm tries to

evaluate additional wealth each projects would generate if undertaken. Basically, quantitative

measures only assist on managerial decision by providing the facts and figures for manager to

prove their decisions to be rational. However, for complete evaluation of capital budgeting,

qualitative measures are equally important.

Some of the important qualitative factors in capital budgeting evaluation are as follows:

First of all, the reliability of figures like cash flows, cost of capital etc which help toevaluate quantitative measures should be ascertained.If these figures are authentic then

only the quantitative measures can be trusted upon.

The vision of judgement of future also plays an important role as factors like marketpotential, possibility of technology change, trend of government policies etc considerably

affect capital budgeting process. The opportunities and constraints of selecting a project, evaluation of qualitative and

quantitative factors, and the weightage on every bit of pros and cons, cost-benefit

analysis are also important in capital budgeting evaluation process.

The effect of capital budgeting on employee moral also has to be considered asemployees are the person who will make the projects successful. Ordering new office

furniture, for example, may not have an immediate, quantifiable payback for the

corporation, but it can boost employee morale and result in greater productivity. Risk associated in all the projects also have to be studied properly and if these risks are

considered then only the outcome capital budgeting process can be reliable.


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Annex

Calculation of Payback Period

Project A

Cash Flows Cumulative Cash Flows


Year 1 136,000 -364,000

Year 2 136,000 -228,000

Year 3 136,000 -92,000

Year 4 618,800 526,800

Payback Period = 3 + (92,000/618,000)

= 3.1486 years

Project B



Year 1 370,000 -130,000

Year 2 270,000 140,000

Year 3 155,000 295,000

Year 4 49,000 344,000

Payback Period = 1 + (130,000/270,000)

= 1.4814 years

Project C


Original Investment -1,000,000 -1,000,000

Year 1 323,000 -677,000

Year 2 323,000 -354,000Year 3 323,000 -31,000

Year 4 323,000 292,000

Year 5 323,000 615,000

Year 6 323,000 938,000

Year 7 323,000 1,261,000

Year 8 323,000 1,584,000


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Year 9 323,000 1,907,000

Year 10 323,000 2,230,000

Payback Period = 3+(1,000,000/323,000)

= 3.0959 years

Project D



Year 1 175,000 -325,000

Year 2 175,000 -150,000

Year 3 175,000 25,000

Year 4 175,000 200,000

Year 5 175,000 375,000

Payback Period = 2+(500,000/175,000)= 2.86 years

Discounted Payback Period for Project A

At 15 % discount rate


0 -500,000 1 -500000 -500000

1 136,000 0.8696 118265.6 -381734.4

2 136,000 0.7695 104652 -277082.4

3 136,000 0.6575 89420 -187662.4

4 618,800 0.5718 353829.84 166167.44

Discounted Payback Period = 3 + (187662.4/353829.84)

= 3.53 years


Year Cash Flows PVIF@21% PV Cumulative CFs0 -500,000 1 -500000 -500000

1 136,000 0.8264 112390.4 -387609.6

2 136,000 0.683 92888 -294721.6

3 136,000 0.5645 76772 -217949.6

4 618,800 0.4665 288670.2 70720.6


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= 3.76 years

Project B



0 -500,000 1 -500000 -500000

1 370,000 0.8696 321752 -178248

2 270,000 0.7695 207765 29517

3 155,000 0.6575 101912.5 131429.5

4 49,000 0.5718 28018.2 159447.7

Discounted Payback Period = 1 + (178248/207765)

= 1.86 years

At 21% discount rate


0 -500,000 1 -500000 -500000

1 370,000 0.8264 305768 -194232

2 270,000 0.683 184410 -9822

3 155,000 0.5645 87497.5 77675.5

4 49,000 0.4665 22858.5 100534

Discounted Payback Period = 2 + (9822/87497.5) = 2.11 years

Project C @ 15 % discount rate


0 -1,000,000 1 -1000000 -500000

1 323,000 0.8696 280880.8 -219119.2

2 323,000 0.7695 248548.5 29429.3

3 323,000 0.6575 212372.5 241801.8

4 323,000 0.5718 184691.4 426493.2

5 323,000 0.4972 160595.6 587088.8

6 323,000 0.4323 139632.9 726721.7

7 323,000 0.3759 121415.7 848137.4

8 323,000 0.3269 105588.7 953726.1

9 323,000 0.2843 91828.9 1045555


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10 323,000 0.2472 79845.6 1125400.6

Discounted Payback Period = 1 + (219119.2/248548.5) = 1.88 years

Project C @ 21 % discount rate


0 -1,000,000 1 -1000000 -500000

1 323,000 0.8264 266927.2 -233072.8

2 323,000 0.683 220609 -12463.8

3 323,000 0.5645 182333.5 169869.7

4 323,000 0.4665 150679.5 320549.2

5 323,000 0.3855 124516.5 445065.7

6 323,000 0.3186 102907.8 547973.5

7 323,000 0.2633 85045.9 633019.4

8 323,000 0.2176 70284.8 703304.2

9 323,000 0.1799 58107.7 761411.9

10 323,000 0.1486 47997.8 809409.7


= 2.07 years

Project D



0 -500,000 1 -500000 -500000

1 175,000 0.8696 152180 -347820

2 175,000 0.7695 134662.5 -213157.5

3 175,000 0.6575 115062.5 -98095

4 175,000 0.5718 100065 1970

5 175,000 0.7972 139510 141480

Discounted Payback Period = 3 + (98095/100065)

= 3.98 years

At 21% discount rate



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0 -500,000 1 -500000 -500000

1 175,000 0.8264 144620 -355380

2 175,000 0.683 119525 -235855

3 175,000 0.5645 98787.5 -137067.5

4 175,000 0.4665 81637.5 -55430

5 175,000 0.3855 67462.5 12032.5

Discounted Payback Period = 4 + (55430/67462.5)

= 4.68 years

Net Present Value

From above calculation of Discounted Payback Period we can determine the Net Present Value:

Project 15% discount rate 21% discount rate

A 166167.44 70720.6

B 159447.7 100534

C 625400.6 309409.7

D 141480 12032.5

IRR (Internal Rate of Return)

Project A

Year CFs PVIF @ 26% PV PVIF @ 27% PV

0 -500,000 1 -500000 1 -500000

1 136,000 0.7937 107943.2 0.7874 107086.4

2 136,000 0.6299 85666.4 0.62 84320

3 136,000 0.4999 67986.4 0.4882 66395.2

4 618,800 0.3968 245539.84 0.3844 237866.72

NPV 7135.84 -4331.68

IRR = Lower Rate + NPV of LR / NPV of LR - NPV of HR (HRLR)

= 26 + (7135.84/ 7135.84+4331.68) (1)

= 26.62%

Project B


0 -500,000 1 -500000 1 -500000

1 370,000 0.7463 276131 0.7407 274059

2 270,000 0.5569 150363 0.5487 148149


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3 155,000 0.4156 64418 0.4064 62992

4 49,000 0.3102 15199.8 0.3011 14753.9

NPV 6111.8 -46.1

IRR = Lower Rate + NPV of LR / NPV of LR - NPV of HR (HRLR)= 34 + (6111.8/ 6111.8+46.1) (1)

= 34.99%

Project C


0 -1,000,000 1 -1000000 1 -1000000

1 323,000 0.7752 250389.6 0.7692 248451.6

2 323,000 0.6009 194090.7 0.5917 191119.1

3 323,000 0.4658 150453.4 0.4552 147029.64 323,000 0.3611 116635.3 0.3501 113082.3

5 323,000 0.2799 90407.7 0.2693 86983.9

6 323,000 0.217 70091 0.2072 66925.6

7 323,000 0.1682 54328.6 0.1594 51486.2

8 323,000 0.1304 42119.2 0.1226 39599.8

9 323,000 0.1011 32655.3 0.0943 30458.9

10 323,000 0.0784 25323.2 0.0725 23417.5

NPV 26494 -1445.5

IRR = Lower Rate + NPV of LR / NPV of LR - NPV of HR (HRLR)

= 29 + (26494/26494+1445.5) (1)

= 29.95%

Project D


0 -500,000 1 -500000 1 -500000

1 175,000 0.8197 143447.5 0.813 142275

2 175,000 0.6719 117582.5 0.661 115675

3 175,000 0.5507 96372.5 0.5374 94045

4 175,000 0.4514 78995 0.4369 76457.5

5 175,000 0.37 64750 0.3552 62160

NPV 1147.5 -9387.5


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IRR = Lower Rate + NPV of LR / NPV of LR - NPV of HR (HRLR

= 22 + (1147.5/ 1147.5+9387.5) (1)

= 22.11%

EPPP Report-

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