Capital Budgeting, Cost of Capital, Risk and Return Analysis

QUESTION 1 Capital Budgeting
PART A
Maximum Pay Back Period Available= 3.5 years
Initial Cost= $ 500000
Total Operating Cash Flows= ($180,000 + $190,000 + $70,000 + $180,000) = $
620000.
Therefore, the payback period in which the initial cost would be recovered would be
=3.4 years, as shown in calculation below.
YEAR CASHINFLOWS INITIALCOSTRECOVERED
1 180000 180000
2 190000 370000
3 70000 440000
3YEARS, 4MONTHS 60000 500000
Hence, the proposal should be accepted, as the actual payback period is less than
the maximum available payback period.
PART B
Year Cash Flows ($) PVF@15% Present value
0 (1,00,000.00) 1.000 (1,00,000.00)
1 25,000.00 0.870 21,739.13
2 10,000.00 0.756 7,561.44
3 50,000.00 0.658 32,875.81
4 10,000.00 0.572 5,717.53
5 10,000.00 0.497 4,971.77
6 60,000.00 0.432 25,939.66
(1,194.67)
Net present value
NPV
As seen from the above calculation, the NPV of the given project at the given
discount rate of 15 percent, amounts to be negative. Hence, the proposal should be
rejected.
PART C
The most striking theoretical and practical strength of the NPV and the IRR
methods of the investment proposal is that the both the techniques use the time
value of money. The conflicts between the two methods arise in the event of the

comparison of the two mutually exclusive projects. There can be a range of reasons
leading to the conflicting results between the NPV and IRR, listed as follows. The
size and the investment amount of the projects can lead to the conflicting results
because a small project may have low NPV but higher IRR. In addition, the patterns
of the cash flows lead to the conflicting results, where one of the projects lead to the
lump sum cash flows in the last year, and no cash flows during other years. In this
case, the IRR of the said project can be lower while NPV can be higher.
PART D
Year Cash Flows ($) PVF@10% Present value
0 (2,50,000.00) 1.000 (2,50,000.00)
1 75,000.00 0.909 68,181.82
2 75,000.00 0.826 61,983.47
3 75,000.00 0.751 56,348.61
4 75,000.00 0.683 51,226.01
5 75,000.00 0.621 46,569.10
34,309.01
Net present value- MACHINE A
NPV
Year Cash Flows ($) PVF@10% Present value
0 (3,50,000.00) 1.000 (3,50,000.00)
1 2,00,000.00 0.909 1,81,818.18
2 1,50,000.00 0.826 1,23,966.94
3 1,00,000.00 0.751 75,131.48
4 -
5 -
30,916.60
Net present value- MACHINE B
NPV
Machine A has higher NPV that is of 34309, than that of the Machine B that is
30917. Hence as per the NPV, Machine A must be chosen over the Machine B.
The formula for EAA =
C = (r x NPV) / (1 - (1 + r)-n )
Where:
C = equivalent annuity cash flow
NPV = net present value

r = interest rate per period
n = number of periods
Accordingly,
EAA Machine A = (0.10 x $34309) / (1 - (1 + 0.10)-5) = $9050.63
EAA Machine B = (0.10 x $30917) / (1 - (1 + 0.10)-3) = $12432.18
Hence, as evident above, as per EAA, Machine B is more feasible.
The decision is that Machine B must be chosen for the investment.