Question 2: Capital Budgeting Analyse (i). Consider a ten-year project that cost

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Question 2: Capital Budgeting Analyse

(i). Consider a ten-year project that costs $40,000 today, which is expected to generate $6,000 at the end of the second year and then the cash flows will increase by $1,000 for three years and then stagnate for the rest of the project life. The cost of capital is 8 percent. What is the project’s NPV?

(ii). Newfoundland Vintners Co-operative is considering two mutually exclusive projects: Absinth and Brandy. Project Absinth requires a $20,500 cash outlay today and is expected to generate after- tax cash flows of $11,000 in year 1, $8,500 in year 2, and $7,500 in year 3. Project Brandy requires a $30,000 cash outlay today and is expected to generate after-tax cash flows of $7,000 in year 1, $9,000 in year 2, $11,000 in year 3, and $16,000 in year 4. Both project can be replicated at the end of its life. The appropriate discount rate for both projects is 10 percent.

a) Calculate the NPV of both projects. Given that the projects are mutually exclusive and can be replicated, which project should be accepted?

b) Calculate the payback periods of both projects if cash flows occur evenly throughout the year.

c) Calculate the discounted payback periods of both projects if cash flows occur evenly throughout the year.

d) Calculate the profitability index of both projects

e) Which project should the firm choose using the information in (A) – (D)? Why?

Explanation / Answer

1) NPV can be calculated using NPV function on a calculator or excel

Insert CF0 = -40,000, CF1 = 0, CF2 = 6000, CF3 = 7000, CF4 = 8000, CF5 ...CF10 = 9000 and I/Y = 8%

=> Compute NPV = $7,162.69

2) Similarly,

For Absinth, CF0 = -20,500, CF1 = 11,000, CF2 = 8,500, CF3 = 7,500 and I/Y = 10% => Compute NPV = $2,159.65

For Brandy, CF0 = -30,000, CF1 = 7,000, CF2 = 9,000, CF3 = 11,000, CF4 = 16,000 and I/Y = 10% => Compute NPV = $2,994.33

Payback period is the no. of years it takes to recover the investment

For Absinth, Payback period = 2 + (20,500 - 11,000 - 8,500) / 7,500 = 2.13 years

For Brandy, Payback Period = 3 + (30,000 - 7,000 - 9,000 - 11,000) / 16,000 = 3.19 years

Using discounted cash flows, Discounted Payback period for Absinth = 2.62 years

Discounted Payback Period for Brandy = 3.73 years

Profitability Index (PI) = 1 + NPV / Investment

For Absinth, PI = 1 + 2159.65 / 20500 = 1.11

For Brandy, PI = 1 + 2,994.33 / 30,000 = 1.10

Select Project Brandy as it has higher NPV.

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