Sample Questions Of Capital Budgeting

 

1.         (a)       You are required to calculate the total present value of inflow at rate of       discount of 12% of following data.

 

Year end Cash inflows$

1 2,30,0002 2,28,0003 2,78,000

4 2,83,0005 2,73,0006                                     80,000   

(Scrap value) 

(b)       Considering the data given in the above. Calculate the total present value of inflows and outflows if the rate of discount is 10% assuming that $ 10,00,000 of outflows would be spent as follows:

 

            Beginning of year 1                         $ 2,50,000

 

            Beginning of year 2                         $ 2,50,000

 

            Beginning of year 3                         $ 2,50,000

 

            Beginning of year 4                         $ 2,50,000

 

2.         Work out the internal rates of return of the project given in Self-examination question 1 (a) and (b)

 

Answer to sample questions

 1.         (a) Present value of cash inflows 

YearsCash inflows $

Discount factor @ 12%

Present value $

1 2,30,000 0.893 2,05,3902 2,28,000 0.797 1,81,7163 2,78,000 0.712 1,97,9364 2,83,000 0.636 1,79,9885 2,73,000 0.567 1,54,7916 80,000 0.507 40,560

    Total present value 9,60,381 

The student should note that the total present value is lower in this case than 10% rate as used earlier.

             (b) Present value of cash inflows 

YearsCash inflows $

Discount factor @ 10%

Present value $

1 2,30,000 0.909 2,09,0702 2,28,000 0.826 1,88,3283 2,78,000 0.751 2,08,7784 2,83,000 0.683 1,93,2895 2,73,000 0.621 1,69,5336 80,000 0.564 45,120

    Total present value 10,14,118 

Present value of cash outflows

 YearsCash inflows

$Discount factor @

10%Present value $

1 2,50,000 0.909 2,27,2502 2,50,000 0.826 2,06,5003 2,50,000 0.751 1,87,750

      6,21,500 

It may be noted that the year-end of first year and beginning of year two are the same. There is no need to discount the sum of $ 2,50,000 spent at the beginning of year one since the money is immediately spent. The total present value of outflows would therefore be $ 6,21,500 + $ 2,50,000. i.e. $ 8,71,500.

 

2.         (a)       At 8% rate of discount the total present value is $ 1,23,026; at 10% it is $    10,14,118. Hence the internal rate of return would be 9.62%.

 

(b)       In this case the sum of the discounted values of outflows at 10% is $ 8,71,500 and that of inflows is $ 10,14,118. If we increase the rate to 15% the results would be as follows.

 Outflows

Years end

Cash inflows $

Discount factor @ 15%

Present value $

0 2,50,000 1.000 2,50,0001 2,50,000 0.870 2,17,5002 2,50,000 0.756 1,89,0003 2,50,000 0.658 1,65,500

      8,21,000 

InflowsYears end

Cash inflows $

Discount factor @ 15%

Present value $

1 2,30,000 0.870 2,00,1002 2,28,000 0.756 1,72,3683 2,78,000 0.658 1,82,9244 2,83,000 0.572 1,61,8765 2,73,000 0.497 1,35,6816 80,000 0.432 34,560

      8,87,509 

Since the difference between the discounted outflows and inflows is still there we shall have to use a higher rate say 18%.

 Outflows

Years end

Cash inflows $

Discount factor @ 15%

Present value $

0 2,50,000 1.000 2,50,0001 2,50,000 0.847 2,11,7502 2,50,000 0.718 1,79,5003 2,50,000 0.609 1,52,250

      7,93,500 

InflowsYears end

Cash inflows $

Discount factor @ 18%

Present value $

1 2,30,000 0.847 1,94,8102 2,28,000 0.718 1,63,7043 2,78,000 0.609 1,69,3024 2,83,000 0.516 1,46,0285 2,73,000 0.437 1,19,3016 80,000 0.370 29,600

      8,22,745             The internal rate of return is approximately 19%.

Capital Budgeting Techniques Practice Questions

1. Is it possible for a project to have a payback period of 2 years and yet have a negative net present value? Explain. 

2. What is the decision-criteria for the profitability index? Does this criteria agree with that of the net present value technique? 

3. Is it possible for a project's IRR to be less than its MIRR? Explain. 

4. Is it possible for a project to not pay back, according to the discounted payback period method, and yet have a positive net present value? Explain. 

Capital Budgeting Practice Problems

1. Consider the project with the following expected cash flows: 

Year Cash flow

0 -$200,000

1  +50,000

2  +50,000

3  +$200,000

a. If the discount rate is 0%, what is the project's net present value? 

b. If the discount rate is 5%, what is the project's net present value? 

c. What is this project's internal rate of return? 

d. If the reinvestment rate is 5%, what is this project's modified internal rate of return? 

2. Consider a project with the expected cash flows: 

Year Cash flow

0 -$50,000

1 +50,000

2 +100,000

3 -$100,000

a. What is this project's internal rate of return? 

b. If the discount rate is 5%, what is this project's net present value? 

3. A project requiring a $1 million investment has a profitability index of 0.96. What is its net present value? 

Solutions

Problem set-Multiple Choice Questions on Capital Budgeting

2. The term mutually exclusive investments mean:a. Choose only the best investments.b. Selection of one investment precludes the selection of an alternative.c. The elite investment opportunities will get chosen.d. There are no investment options available.

ABC Company is considering two investments both of which cost $10,000. The cash flows are as follows:

Year Project A Project B1 $6,000 $5,0002 4,000 3,0003 3,000 8,000

3. Based on the payback method, which of the two projects should be chosen?a. Project A which has a payback period of 2.0 years.b. Project A which has a payback period of 2.25 years.c. Project B which has a payback period of 2.0 years.d. Project B which has a payback period of 2.25 years.

4. Based on the net present value method, assuming a cost of capital of 10%, which of the two projects should be chosen?a. Project A which has a net present value of $11,011.b. Project A which has a net present value of $1,011.c. Project B which has a net present value of $13,031d. Project B which has a net present value of $3,031.

5. Which method provides more confidence, the payback method or the net present value method?a. Payback because it provides a good timetable.b. Payback because it tells you when you break even.c. Net present value because it considers all inflows and outflows and the time value of money.d. Net present value because it does not need to use cost of capital.

The Pan American Bottling Co. is considering the purchase of a new machine that would increase the speed of bottling and save money. The net cost of this machine is $45,000. The annual cash flows have the following projections.

Year Cash Flow1 $15,0002 20,0003 25,0004 10,0005 5,000

6. What is the net present value of selecting the new machine, assuming cost of capital of 10%?a. $11,883b. $13,883c. $15,883d. $17,883

7. What is the internal rate of return?a. About 7%b. About 10%c. About 23%d. About 27%

8. Should Pan American buy the machine?a. Yes. NPV is positive and IRR exceeds cost of capital.b. Yes. NPV is positive and IRR is less than cost of capital.c. No. NPV does not provide enough information.d. No. IRR is higher than the cost of capital.

Big Sky Construction Company is considering two new investments. Project E calls for the purchase of earth-moving equipment. Project H represents the investment in a hydraulic lift. Big Sky wishes to use a new present value profile in comparing the projects. The investment and cash flow patterns are as follows:

Project E($20,000 investment) Project H($20,000 investment)Year Cash Flow1 $ 5,0002 6,0003 7,0004 10,000 Year Cash Flow1 $16,0002 5,0003 4,000

9. What is the NPV of both projects using zero discount rate?a. $8,000 for project E and $5,000 for project Hb. $8,000 for project H and $5,000 for project Ec. $28,000 for project E and $25,000 for project Hd. $20,000 for both projects.

10. What is the NPV of both projects using 9% discount rate?a. $22,121 for project E and $21,970 for project Hb. $20,000 for both projects.c. $2,121 for project E and $1,970 for project Hd. $8,000 for project E and $5,000 for project H

11. The IRR of project E is _______a. About 9%b. About 13%c. About 16%d. About 20%

12. If the two projects are mutually exclusive, which project would you accept using NPV, assuming cost of capital of 18%.

a. Project Eb. Project Hc. Bothd. Neither

13. Risk-averse managers will generally require _____ return from risky investments.a. Lowerb. Zeroc. Higherd. Negative

14. The concept of risk can be incorporated into the capital budgeting process by using higher discount rates for riskier investments.a. Trueb. False

15. If risk is to be analyzed in a qualitative way, which is the least risky?a. New equipmentb. New marketc. Repair of old machineryd. New product in a foreign market

Best Technology Corp. is evaluating the introduction of a new product. The possible levels of unit sales and the probabilities of their occurrence are given.

PossibleMarket Reaction Salesin Units

ProbabilitiesLow response 20 .10Moderate response 40 .20High response 65 .40Very high response80 .30

16. What is the expected value of unit sales for new product?a. 20b. 30c. 45d. 60

17. What is the standard deviation of unit sales?a. 370b. 160c. 19.2d. 5.8

18. Project A has an expected return of $1,000 and a standard deviation of $590. Project B has expected return of $3,000 and a standard deviation of $750. Using coefficient of variation, which has a lower risk?a. Project A, because coefficient of variation is higher.b. Project A, because coefficient of variation is lower.c. Project B, because coefficient of variation is higher.d. Project B, because coefficient of variation is lower.

19. A company with a beta of 1.50 is considered to have lower level of risk than the stock market in general.a. Trueb. False

20. A company is considering the purchase one of two companies. Both of these companies have an expected return of 15% with the same standard deviation of returns. Company 1 has a positive correlation of returns with the acquiring company, while company 2 has a negative correlation. Which company should the acquiring company purchase if it must purchase one of them?a. Company 1 because it reduces riskb. Company 1 because it increases returnc. Company 2 because it reduces riskd. Company 2 because it increases return

Cash Budgets Page 2: Solution and Question

The Cash Budget Solution Pictures

Here's a question that is remarkably like the exercise you've just worked through on Cash Budgets Page 1. Do your best and use the forms and pictures from page 1 to help you.

The opening balance of cash is to be £5,000 (that's the balance b/d for Month 1).

For this business, the sales plans and debtors details are as follows: 

Credit SalesMonth 1

Month 2

Month 3

42,000 22,000 36,000Month 4

Month 5

Month 6

45,500 38,000 44,000

The business has three classes of debtor: Debtors 1, 2 and 3 and they pay their debts according to this table 

Payment History of DebtorsWhich Debtors

When They Pay How Many of Them Pay at This Time

Debtors 1 within the month of sale 60%Debtors 2 in the month after sale 30%Debtors 3 in the second month after sale 10%

For this business, the purchase plans and creditors details are as follows: 

Payment History for CreditorsMonth 1Month 2 Month 329,000 26,750 38,500Month 4Month 5 Month 6

22,000 20,000 31,000

The business has three classes of creditor: Creditors 1, 2 and 3 and we pay our debts according to this table 

Payment History for CreditorsWhich Creditors

When We Pay How We Pay at This Time

Creditors 1 within the month of sale 75%Creditors 2 in the month after sale 20%Creditors 3 in the second month after sale 5%

 

Final words from me are that the balance c/d of the cash budget at the end of Month 3 is £5,113; the Total Receipts from Debtors for Month 6 is £42,350; and the Total Payments to Creditors for Month 6 is £28,350.