Mini case

Name: Yi Ru 1077406Class: FINC501-M01Assignment of mini caseOctober 27, 2015A. What is capital budgeting?Capital budgeting is the whole process of analyzing projects and deciding which ones to accept and thus include in the capital budget.B. What is the difference between independent and mutually exclusive projects? Independent projects means that I have so much money that I can invest a lot of projects at the same time. So if the profits are higher than my expectation, I will invest it. Mutually exclusive projects means that my money is limited so I must choose the best one of the investments. If I choose the one of them, I cannot choose others at all.C. (1) Define the term NPV. What is each franchise’s NPV?The rationale of the NPV method is defined as the present value of a project’s expected cash flows discounted at the appropriate risk-adjusted rate.The Franchise L’s NPV is $18.7829.The Franchise S’s NPV is $19.9850.(2) What is the rationale behind the NPV method? Acoording to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive?The NPV method help us know the present value of future cash flows are equal to investment which is made today. If the NPV more than zero, it will be worthy investing. If they are independent, both of them should be invested because the NPVs of them are positive. If they are Mutually exclusive, the Franchises S should be invested duo to its higher NPV.(3) Would the NPVs change if the cost of capital changed?Yes, if the cost of capital goes up, the NPVs will go down.D. (1) Define the term IRR. What is each franchise’s IRR?IRR is the rate of return when NPV=0.The Franchise L’s IRR is 18.1258%.The Franchise S’s IRR is 23.5641%.(2) How is the IRR on a project related to the YTM on a bond?They are the same thing. If you invest in the bond, the YTM of the bond is the IRR.(3) What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?IRR measures a project’s profitability in the rate of return sense: if a project’s IRR equals its cost of capital, then its cash flows are just sufficient to provide investors with their required rates of return. If they are independent, both of them should be invested because the IRRs of them are both higher than 10%. If they are mutually exclusive, Franchise S should be invested due to its higher IRR.(4) Would the franchises’ IRRs change if the cost of capital changed?No, IRRs are independent of the cost of capital.E. (1) Draw NPV profiles for Franchises L and S. At what discount rate do the profiles cross?The data of the curve shows below.R NPVL NPVS0.00% $50.00 $40.005.00% $31.48 $27.9010.00% $17.08 $18.1715.00% $5.80 $10.2820.00% -$3.09 $3.86Crossover pointX=8.7%IRRL=18.1% IRRS=23.6%The discount rate is 8.7% when crossing .(2)Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which franchise or franchises should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any cost of capital less than 23.6%?If they are independent, L should be accepted when its cost of capital less than 18.1% and S should be accepted when its cost of capital less than 23.6% where the NPV is more than zero. If they are mutually exclusive, L should be invested when its cost of capital less than 8.7% where the NPV of L is higher and S should be invested when its cost of capital more than 8.7% where.the NPV of S is higher.F. What is the underlying cause of ranking conflicts between NPV and IRR?①The different scale of two projects②Cash flows differ in terms of time pattern of their cash flowsG. Define the term modified IRR (MIRR). Find the MIRRs for Franchises L and S. MIRR is that discount rate which equates the present value of the terminal value of the inflows, compounded at the cost of capital, to the present value of the cost.The MIRR for Franchises L is 16.4959%.The MIRR for Franchises S is 16.8876%.H. What does the profitability index (PI) measure? What are the PIs of Franchises S and L?PI measures the “bang for the buck”.PI of L is 1.1879.PI of S is 1.1998.I. (1) What is the payback period? Find the paybacks for Franchises L and S?PBP is the number of years required to recover a project’s cost, or how long does it take to get the business’s money back?The payback for L is 2.375 years.The payback for S is 1.6 years.(2)What is the rationale for the payback method? According to the payback criterion, which franchise or franchises should be accept if the firm’s maximum acceptable payback is 2 years and if Franchises L and S are independent? If they are mutually exclusive?PBP measures a balance point of the cash flows. It finds the time point when taking the money back.. If the firm’s maximum acceptable payback is 2 years and if L and S are independent, L should be rejected because its PBP is longer than 2 years, and S should be accepted because the PBP of S is shorter than 2 years. If they are mutually exclusive, S should be accept duo to its shorter PBP.(3)What is the difference between the regular and discounted payback period?The latter uses discounted cash flows, so the discounted payback period considered the time value of the cash flows. It is more accurate than the PBP.(4)What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions?Ignores cash flows occurring after the payback period. In spite of its deficiency, many firms today still calculate the discounted payback and give some weight to it when making capital budgeting decisions. However, payback is not generally used as the primary decision tool. Rather. It is used as a rough measure of a project’sliquidity and riskiness.J. As a separate project (project P), you are considering sponsoring a pavilion at the upcoming world’s fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, project P’s expected net cash flows look like this (in millions of dollars):Year Net Cash Flows0 -$0.81 5.02 -5.0The project is estimated to be of average risk, so its cost of capital is 10 percent. (1) What are normal and nonnormal cash flows?Normal cash flow begin with a negative cash flow (or a series of negative cash flows), switch to positive cash flows, and then remain positive. They have only one change in sign. Nonnormal cash flows have more than one sign change. For example, they may start with negative cash flows, switch to positive, and then switch back to negative.(2) What is Project P’s NPV? What is its IRR? Its MIRR?Project P’s NPV is -$386.776.86.IRR is 25%.MIRR is 5.6%.(3) Draw Project P’s NPV profile. Does Project P have normal or nonmormal cash flows? Should this project be accepted?The data of the curve shows below.rate NPV0% -$800,000.0025% $0.0050% $207,407.4175% $242,565.60100% $225,000.00125% $193,141.29150% $160,000.00175% $129,827.20200% $103,703.70225% $81,565.77250% $62,973.76275% $47,407.41300% $34,375.00325% $23,448.00350% $14,266.12375% $6,531.56400% $0.00Obviously, Project P have nonnormal cash flows. The project P should be rejected because its NPV is less than zero at the rate 10%.K. In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects, Project T (which lasts for two years) and Project F (which lasts for four years):Expected Net Cash FlowsYear Project T Project F0 -$100,000 -100,0001 60,000 33,5002 60,000 33,5003 33,5004 33,500The projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have a 10% cost of capital. (1) What is each project’s initial NPV without replication?NPV of T is $4,132.23.NPV of F is $6,190.49.(2) What is each project’s equivalent annual annuity?EAA of T is $2,380.95.EAA of F is $1,952.92.(3) Apply the replacement chain approach to determine the projects’extended NPVs. Which project should be chosen?The replacement chain approach means that the project T will be reinvested twice.So the NPV of F is still $6,190.49.And the NPV of T is 4,132.23+4,132.23/(1+10%)2=$7,547.30.The Project T should be chosen.(4) Assume that the cost to replicate Project T in 2 years will increase to $105,000 due to inflation. How should the analysis be handled now, and which project shouldbe chosen?If the cost to replicate Project T will increase to $105,000, I will invest $105,000 and have a $60,000 return, that is equal to investing $45,000. So the cash flow should be:Year Project T Project F0 -$100,000 -100,0001 60,000 33,5002 -45,000 33,5003 60,000 33,5004 60,000 33,500The new NPV of T is $3,415,07, which is less than the NPV of F.So Project F should be chosen.L. You are also considering another project that has a physical life of 3 years; that is , the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the project’s estimated cash flows:Year Initial Investment andOperating Cash FlowsEnd-of-Year NetSalvage Value0 -$5,000 -$5,0001 2,100 3,1002 2,000 2,0003 1,750 0Using the 10% cost of capital, what is the project’s NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of Year 1? What is the project’s optimal (economic) life?(1)If no terminationYear CF0 -$5,0001 2,1002 2,0003 1,750NPV= -$123.22(2)Terminate after 2 yearsYear CF0 -$5,0001 2,1002 4,000NPV= $214.88(3)Terminate after 1 yearYear CF0 -$5,0001 5,200NPV= -$272.73So the project’s optimal (economic) life is 2 years, which is not equal to the engineering life 3 years.。