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    Tutorial 6 Solutions

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    Alexander D'Amore
    The document provides answers to tutorial questions on capital budgeting techniques. It defines key terms like cost of capital, hurdle rate, mutually exclusive projects, and capital rationing. It explains how to calculate net present value and payback period. Several examples are provided to illustrate how to use these techniques to evaluate potential capital investments and choose the one with the highest net present value.

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    Tutorial 6 Solutions

    Uploaded by

    Alexander D'Amore
    70 views3 pages
    The document provides answers to tutorial questions on capital budgeting techniques. It defines key terms like cost of capital, hurdle rate, mutually exclusive projects, and capital rationing. It explains how to calculate net present value and payback period. Several examples are provided to illustrate how to use these techniques to evaluate potential capital investments and choose the one with the highest net present value.

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    The document provides answers to tutorial questions on capital budgeting techniques. It defines key terms like cost of capital, hurdle rate, mutually exclusive projects, and capital rationing. It explains how to calculate net present value and payback period. Several examples are provided to illustrate how to use these techniques to evaluate potential capital investments and choose the one with the highest net present value.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    70 views3 pages

    Tutorial 6 Solutions

    Uploaded by

    Alexander D'Amore
    The document provides answers to tutorial questions on capital budgeting techniques. It defines key terms like cost of capital, hurdle rate, mutually exclusive projects, and capital rationing. It explains how to calculate net present value and payback period. Several examples are provided to illustrate how to use these techniques to evaluate potential capital investments and choose the one with the highest net present value.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 3

    Tutorial 6: Valuation – Investments (tutorial in week 7)

    1. Explain why the cost of capital is referred to as the ‘hurdle’ rate in capital budgeting.

    Answers:
    The cost of capital is the minimum required return on any new investment that allows
    a company to break even. Since we are using the cost of capital as a benchmark or
    “hurdle” to compare the return earned by any project, it is sometimes referred to as
    the hurdle rate.

    2. What are the differences between capital projects that are independent, mutually
    exclusive and contingent?

    Answers:
    A project is independent if the decision to accept or reject it does not affect the decision
    to accept or reject another project. On the other hand, projects are mutually exclusive
    if the acceptance of one implies rejection of the other. Contingent projects are those in
    which the acceptance of one project is dependent on another project.

    3. In the context of capital budgeting, what is ‘capital rationing’?

    Answers:
    Capital rationing implies that a company does not have the resources necessary to fund
    all of the available projects. In other words, funding needs exceed funding resources.
    Thus, the available capital will be allocated to the projects that will benefit the company
    and its shareholders the most. Projects that create the largest increase in shareholder
    wealth will be accepted until all the available resources have been allocated.

    4. A company takes on a marketing project that would earn a return of 12 per cent. If
    the appropriate cost of capital is also 12 per cent, did the company make the right
    decision? Explain.

    Answers:
    We would normally argue that a company should only accept projects in which the
    project’s return exceeds the cost of capital. In other words, only if the net present
    value exceeds zero should a project be accepted. But in reality, projects with a zero
    NPV should also be accepted because the project earns a return that equals the cost
    of capital. For some companies like the one above, this could be the situation because
    they may not have projects that provide a return greater than the cost of capital for
    the company.

    1
    5. What is the impact on the company if it accepts a project with a negative NPV?

    Answers:
    When a company takes on positive NPV projects, the value of the company
    increases. By the same token, when a project undertaken has a negative NPV, the
    value of the company will decrease by the amount of the net present value.

    6. Identify the weaknesses of the payback period method.

    Answers:
    There are several critical weaknesses in the payback period approach of evaluating
    capital projects.

     The payback period ignores the time value of money by not discounting future
    cash flows.
     When comparing projects, it ignores risk differences between the projects.
     A company may establish payback criteria with no economic basis for that
    decision and thereby run the risk of losing out on good projects.
     The method ignores cash flows beyond the payback period, thus leading to
    nonselection of projects that may produce cash flows well beyond the payback
    period or more cash flows than accepted projects. This leads to a bias against
    longer-term projects.

    7. Franklin Mints, a confectioner, is thinking of purchasing a new jellybean-making


    machine at a cost of $312 500. The company projects that the cash flows from this
    investment will be $121 450 for the next 7 years. If the appropriate discount rate is
    14 per cent, what is the NPV for the project?

    Answers:
    Initial investment = $312,500
    Annual cash flows = $121,450
    Length of project = n = 7 years
    Required rate of return = k = 14%
    n NCF
    NPV   t

    t  0 (1  k )
    t

    $121,450 $121,450 $121,450 $121,450 $121,450


     $312,500     
    (1.14)1 (1.14) 2 (1.14)3 (1.14) 4 (1.14)5
    $121,450 $121,450
     
    (1.14)6 (1.14)7
     $312,500  $106,535  $93,452  $81,975  $71,908  $63,077  $55,331  $48,536
     $208,315

    8. Quant Ltd is purchasing machinery at a cost of $3 768 966. The company expects, as


    a result, cash flows of $979 225, $1 158 886 and $1 881 497 over the next 3 years.
    What is the payback period?

    2
    Answers:
    Cumulative
    Year CF Cash Flow
    0 $(3,768,966) $(3,768,966)
    1 979,225 (2,789,741)
    2 1,158,886 (1,630,855)
    3 1,881,497 250,642

    PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
    = 2 + ($1,630,855 / $1,881,497) = 2.87 years

    9. Champlain Ltd is investigating two computer systems. The Alpha 8300 costs
    $3 122 300 and will generate annual cost savings of $1 345 500 over the next 5
    years. The Beta 2100 system costs $3 750 000 and will produce cost savings of
    $1 125 000 in the first 3 years and then $2 million for the next 2 years. If the
    company’s discount rate for similar projects is 14 per cent, what is the NPV for the
    two systems? Which one should be chosen based on the NPV?

    Answers:
    Cost of Alpha 8300 = $3,122,300
    Annual cost savings = $1,345,500
    Length of project = n = 5 years
    Required rate of return = k = 14%
     1 
     1
    n FCFt (1.14)5 
    NPV    $3,122,300  $1,345,500   
    t  0 (1  k )
    t
     0.14 
     
     $3,122,300  $4,619,210
     $1,496,910

    Cost of Beta 2100 = $3,750,000


    Length of project = n = 5 years
    Required rate of return = k = 14%
     1 
     1
    n
    FCFt (1.14)3  $2,000,000 $2,000,000
    NPV    $3,750,000  $1,125,000    
    t  0 (1  k )
    t
     0.14  (1.14) 4 (1.14)5
     
     $3,750,000  $2,611,836  $1,184,161  1,038,737
     $1,084,734
    Based on the NPV, the Alpha 8300 system should be chosen.

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