31 May Question Capital Budeting Methods
Question
Capital Budeting Methods
(10–10) Capital Budgeting Methods
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?
Inputs
r
12%
Initial Cost
Time
Project S
Project L
0
-$10,000
-$25,000
Project S
NPV
IRR
MIRR
PI
$814.33
15.24%
13.77%
1.081
Cash Flows
1
$3,000
$7,400
2
$3,000
$7,400
3
$3,000
$7,400
4
$3,000
$7,400
Project L
$1,675.34
14.67%
13.46%
1.067
5
$3,000
$7,400
Initial Cost
Year
Proj S
0
1
2
3
4
5
-10000
2678.57142857
2391.58163265
2135.34074344
1906.55423521
1702.28056716
Proj L
-25000
6607.1429
5899.2347
5267.1738
4702.8338
4198.9587
Which Project is to be selected?
Using NPV, Project S wins with 814.33 vs 1,675.34
Using IRR, Project S also wins with 15.24% vs 14.67%
Using MIRR, Project S also wins with 13.77% vs 13.46%
Using PI, again, project S wins with 1.081 vs 1.067
Overall, although project L has an NPV higher than project S, in both IRR and MIRR, S is higher. PI is also smaller for project S, so I would choose S over L
(10–17) Unequal Lives
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 ?
Unequal Lives
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