Capital Budgeting Decision: NPV vs IRR

1a) Randolf should use NPV method to make its capital budgeting decision
b) IRR, Payback, Discounted Payback are some other methods which are sometimes used to
make capital budgeting decisions
Randolf should use NPV instead of IRR or any other method because NPV values the exact
amount of profit or loss from the Investment and from the data given it will be possible to
calculate NPV
NPV for Randolf will be : (10 + 10(1.03)/(WACC- 0.03))/WACC – 70
It won't be possible to calculate IRR as the period is perpetuity.
c) To find out if Randolf should go with the investment, we need to find out the NPV
Debt/Equity : 2/3
Thus the weight of debt: 40%
Weight of Equity: 60%
Calculation of Re:
Re = Rf + (rm-rf)B
5.5% + 5.2%*1.2 = 11.74%
Calculation of WACC
Weights Cost Weighted cost
Equity 0.6 11.74% 7.04%
Debt 0.4 6.50% 2.60%
9.64%
Calculation of NPV

Year CF Discount rate PV
0 $ (70.00) 1.0000 $ (70.00)
1 $ 10.00 0.9120 $ 9.12
1 $ 155.03 0.9120 $ 141.39
$ 80.51
Thus NPV: $80.51 Mn
Since NPV is positive, Randolf should go ahead with the investment

2a) WACC is the weighted average cost of capital, it takes into account cost of both equity
and debt, where weights are taken either as market value or book value, whereas expected
return on equity is the return on equity only and not for the company as a whole
We would use WACC to discount, when the project is funded by both debt and equity, for
example, if we are valuing companies and discounting its cashflows, we will use WACC
IF we are valuing a project, which will be funded entirely by equity, then we will use Return
on Equity only.
b)
Value of Debt (Bn)
Enterprise value $ 14.40
Market capitalization $ 10.80
Value of Debt $ 3.60
Cost of Debt:
Kd(1-t)
6.1%(1-35%) 3.97%
Calculation of WACC
Value Weights Cost Weighted cost
Equity $ 10.80 0.75 10.00% 7.50%
Debt $ 3.60 0.25 3.97% 0.99%
$ 14.40 8.49%
WACC: 8.49%
c)

Calculation of NPV
Year CF Discount rate PV
0 $ (100.00) 1.0000 $ (100.00)
1 $ 50.00 0.9217 $ 46.09
2 $ 100.00 0.8496 $ 84.96
3 $ 70.00 0.7831 $ 54.82
$ 85.86
Net present value: $85.86 Bn
No, the risk of this projects FCF is not the same as that of other assets. This project has got its
inherent risk, and other assets have its inherent risks