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

he Fundamentals of Capital Budgeting

 

 

Section 10.1

1.      Why capital investments are considered the most important decisions made by a firm’s management?

 

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

 

Section 10.2

1.                  What is the NPV of a project?

 

2.                  If a firm accepts a project with a $10,000 NPV, what is the effect on the value of the firm?

3.            What are the five steps used in NPV analysis?

The five-step process used in the NPV analysis can be listed as follows:

 

Section 10.3

1.                  What is the payback period?

 

 

2.                  Why does the payback period provide a measure of a project’s liquidity risk?

 

3.         What are the main shortcomings of the payback method?

 

 

Section 10.4

1.            What are the major shortcomings of using the ARR method as a capital budgeting method?

 

Section 10.5

1.      What is the IRR method?

 

2.      In capital budgeting, what is a conventional cash flow pattern?

 

 

3.      Why should the NPV method be the primary decision tool used in making capital investment decisions?

 

Section 10.6

1.   What changes have taken place in the capital budgeting techniques used by U.S. companies?

 

Self-Study Problems

 

10.1     Premium Manufacturing Company is evaluating two forklift systems to use in its plant that produces the towers for a windmill power farm. The costs and the cash flows from these systems are shown below. If the company uses a 12 percent discount rate for all projects, determine which forklift system should be purchased using the net present value (NPV) approach.

 

	Year 0	Year 1	Year 2	Year 3
Otis Forklifts	−$3,123,450	$979,225	$1,358,886	$2,111,497
Craigmore Forklifts	−$4,137,410	$875,236	$1,765,225	$2,865,110

 

 

10.2     Rutledge, Inc., has invested $100,000 in a project that will produce cash flows of $45,000, $37,500, and $42,950 over the next three years. Find the payback period for the project.

 

 

10.3     Perryman Crafts Corp. is evaluating two independent capital projects that together will cost the company $250,000. The two projects will provide the following cash flows:

 

Year	Project A	Project B
1	$80,750	$32,450
2	$93,450	$76,125
3	$40,325	$153,250
4	$145,655	$96,110

 

 

Which project will be chosen if the company’s payback criterion is three years?  What if the

company accepts all projects as long as the payback period is less than five years?

 

10.4     Terrell Corp. is looking into purchasing a machine for its business that will cost $117,250 and will be depreciated on a straight-line basis over a five-year period. The sales and expenses (excluding depreciation) for the next five years are shown in the following table. The company’s tax rate is 34 percent.

 

	Year 1	Year 2	Year 3	Year 4	Year 5
Sales	$123,450	$176,875	$242,455	$255,440	$267,125
Expenses	$137,410	$126,488	$141,289	$143,112	$133,556

 

The company will accept all projects that provide an accounting rate of return (ARR) of at least 45 percent. Should the company accept this project?

 

 

 

The company will accept all projects that provide an accounting rate of return (ARR) of at least 45 percent. Should the company accept the project?

 

10.5          Refer to Problem 10.1. Compute the IRR for each of the two systems. Is the investment decision different from the one determined by NPV?

Critical Thinking Questions

 

10.1     Explain why the cost of capital is referred to as the “hurdle” rate in capital budgeting.

 

 

10.2     a.   A company is building a new plant on the outskirts of Smallesville. The town has offered to donate the land, and as part of the agreement, the company will have to build an access road from the main highway to the plant. How will the project of building the road be classified in capital budgeting analysis?

 

b.   Sykes, Inc., is considering two projects: a plant expansion and a new computer system for the firm’s production department. Classify these projects as independent, mutually exclusive, or contingent projects and explain your reasoning.

 

c.   Your firm is currently considering the upgrading of the operating systems of all the firm’s computers. The firm can choose the Linux operating system that a local computer services firm has offered to install and maintain. Microsoft has also put in a bid to install the new Windows operating system for businesses. What type of project is this?

 

10.3     In the context of capital budgeting, what is “capital rationing”?

 

 

10.4Provide two conditions under which a set of projects might be characterized as mutually exclusive.

 

 

 

10.5a.A firm invests in a project that would earn a return of 12 percent. If the appropriate cost of capital is also 12 percent, did the firm make the right decision. Explain.

 

     b.What is the impact on the firm if it accepts a project with a negative NPV?

 

 

10.6     Identify the weaknesses of the payback period method..

 

10.7     What are the strengths and weaknesses of the accounting rate of return (ARR) approach?

 

10.8     Under what circumstances might the IRR and NPV approaches have conflicting results?

 

10.9     The modified IRR (MIRR) alleviates two concerns with using the IRR method for evaluating capital investments. What are they?

 

10.10   Elkridge Construction Company has an overall (composite) cost of capital of 12 percent. This cost of capital reflects the cost of capital for an Elkridge Construction project with average risk. However, the firm takes on projects of various risk levels. The company experience suggests that low-risk projects have a cost of capital of 10 percent and high-risk projects have a cost of capital of 15 percent. Which of the following projects should the company select to maximize shareholder wealth?

Questions and Problems

 

BASIC

 

10.1     Net present value: Riggs Corp. management is planning to spend $650,000 on a new marketing campaign. They believe that this action will result in additional cash flows of $325,000 over the next three years. If the discount rate is 17.5 percent, what is the NPV on this project?

LO 2

 

 

10.2     Net present value: Kingston, Inc. management is considering purchasing a new machine at a cost of $4,133,250. They expect this equipment to produce cash flows of $814,322, $863,275, $937,250, $1,017,112, $1,212,960, and $1,225,000 over the next six years. If the appropriate discount rate is 15 percent, what is the NPV of this investment?

LO 2

 

10.3     Net present value: Crescent Industries management is planning to replace some existing machinery in its plant. The cost of the new equipment and the resulting cash flows are shown in the accompanying table. If the firm uses an 18 percent discount rate, should management go ahead with the project?

Year	Cash Flow
0	−$3,300,000
1	$875,123
2	$966,222
3	$1,145,000
4	$1,250,399
5	$1,504,445

LO 2

 

10.4     Net present value:Franklin Mints, a confectioner, is considering purchasing a new jellybean-making machine at a cost of $312,500. The company’s management projects that the cash flows from this investment will be $121,450 for the next seven years. If the appropriate discount rate is 14 percent, what is the NPV for the project?

LO

10.5     Net present value: Blanda Incorporated management is considering investing in two alternative production systems. The systems are mutually exclusive, and the cost of the new equipment and the resulting cash flows are shown in the accompanying table.  If the firm uses a 9 percent discount rate for their production systems, in which system should the firm invest?

LO 2

 

 

Year		System 1		System 2
0		-15,000		-45,000
1		15,000		32,000
2		15,000		32,000
3		15,000		32,000

 

 

10.6     Payback:  Refer to problem 10.5.  What are the payback periods for production systems 1 and 2?  If the systems are mutually exclusive and the firm always chooses projects with the lowest payback period, in which system should the firm invest?

LO 3

 

 

 

10.7     Payback: Quebec, Inc., is purchasing machinery at a cost of $3,768,966. The company’s management expects the machinery to produce cash flows of $979,225, $1,158,886, and $1,881,497 over the next three years, respectively. What is the payback period?

LO 3

 

 

10.8     Payback: Northern Specialties just purchased inventory-management computer software at a cost of $1,645,276. Cost savings from the investment over the next six years will be reflected in the following cash flow stream: $212,455, $292,333, $387,479, $516,345, $645,766, and $618,325. What is the payback period on this investment?

LO 3

 

 

10.9     Payback: Nakamichi Bancorp has made an investment in banking software at a cost of $1,875,000. Management expects productivity gains and cost savings over the next several years. If the firm is expected to generate cash flows of $586,212, $713,277, $431,199, and $318,697 over the next four years, what is the investment’s payback period?

LO 3

 

 

10.10   Average accounting rate of return (ARR): Capitol Corp. is expecting a project to generate after-tax income of $63,435 over each of the next three years. The average book value of its equipment over that period will be $212,500. If the firm’s acceptance decision on any project is based on an ARR of 37.5 percent, should this project be accepted?

LO 4

 

 

10.11   Internal rate of return:Refer to Problem 10.4. What is the IRR that Franklin Mints management can expect on this project?

LO 5

 

10.12   Internal rate of return:Hathaway, Inc., a resort company, is refurbishing one of its hotels at a cost of $7.8 million. The firm expects that this will lead to additional cash flows of $1.8 million for the next six years. What is the IRR of this project? If the appropriate cost of capital is 12 percent, should Hathaway go ahead with this project?

LO 5

 

 

INTERMEDIATE

 

10.13   Net present value: Champlain Corp. 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 five years. The Beta 2100 system costs $3,750,000 and will produce cost savings of $1,125,000 in the first three years and then $2 million for the next two years. If the company’s discount rate for similar projects is 14 percent, what is the NPV for the two systems? Which one should be chosen based on the NPV?