Exam 12: Capital Budgeting: Decision Criteria

The NPV and IRR methods, when used to evaluate an independent project, will lead to different accept/reject decisions unless the IRR is greater than the cost of capital.

The capital budgeting director of Sparrow Corporation is evaluating a project which costs $200,000, is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm's cost of capital is 14 percent and its tax rate is 40 percent, what is the project's IRR?

The NPV method's assumption that cash inflows are reinvested at the cost of capital is more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This makes the NPV method preferable to the IRR method.

The Seattle Corporation has been presented with an investment opportunity which will yield end-of-year cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10 percent. What is the NPV for this investment?

Jones Company's new truck has a cost of $20,000, and it will produce end-of-year net cash inflows of $7,000 per year for 5 years. The cost of capital for an average-risk project like the truck is 8 percent. What is the sum of the project's IRR and its MIRR?

The internal rate of return is that discount rate which equates the present value of the cash outflows (or costs) with the present value of the cash inflows.

Projects A and B have the same expected lives and initial cash outflows. However, one project's cash flows are larger in the early years, while the other project has larger cash flows in the later years. The two NPV profiles are given below: Which of the following statements is most correct?

Doherty Industries wants to invest in a new computer system. The company only wants to invest in one system, and has narrowed the choice down to System A and System B. System A requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $60,000 at the end of each of the next two years. The system can be replaced every two years with the cash inflows and outflows remaining the same. System B also requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $48,000 at the end of each of the next three years. System B can be replaced every three years, but each time the system is replaced, both the cash inflows and outflows increase by 10 percent. The company needs a computer system for the six years, after which time the current owners plan on retiring and liquidating the firm. The company's cost of capital is 11 percent. What is the NPV (on a six-year extended basis) of the system which creates the most value to the company?

Given two mutually exclusive projects and a zero cost of capital, the payback method and NPV method of selecting investments will always lead to the same decision on which project to undertake.

Assume that you are comparing two mutually exclusive projects. Which of the following statements is most correct?

As the capital budgeting director for Chapel Hill Coffins Company, you are evaluating construction of a new plant. The plant has a net cost of $5 million in Year 0 (today), and it will provide net cash inflows of $1 million at the end of Year 1, $1.5 million at the end of Year 2, and $2 million at the end of Years 3 through 5. Within what range is the plant's IRR?

A project has an up-front cost of $100,000. The project's WACC is 12 percent and its net present value is $10,000. Which of the following statements is most correct?

Alyeska Salmon Inc., a large salmon canning firm operating out of Valdez, Alaska, has a new automated production line project it is considering. The project has a cost of $275,000 and is expected to provide after-tax annual cash flows of $73,306 for eight years. The firm's management is uncomfortable with the IRR reinvestment assumption and prefers the modified IRR approach. You have calculated a cost of capital for the firm of 12 percent. What is the project's MIRR?

Which of the following statements is most correct?

If the IRR of normal Project X is greater than the IRR of mutually exclusive Project Y (also normal), we can conclude that the firm will select X rather than Y if X has a NPV > 0.

King Racing Company (KRC) is considering which of two mutually exclusive engine development projects to pursue. King's RPX design has an expected life of 4 years and projected cash inflows are $3.6 million at the end of each of the first two years and $1.8 million in each of the next two years. King's RPB design is more flexible and has an eight-year life. The projected end-of-year flows from the RPB design are $2.4 million in each of the first two years and $2.0 million in each of the next six years. Both projects require an initial investment of $5.4 million, and King's cost of capital is 12 percent. Frequent changes in racing rules and engine technology make engine development risky, but King feels that the basic designs can be refined and modified. Thus, King often assumes that continuous replacements can be made as a project's life ends. What is the net present value (on an eight-year extended basis) of the project with the most value to the company?

Any capital budgeting investment rule should depend solely on forecasted cash flows and the opportunity cost of capital. The rule itself should not be affected by managers' tastes, the choice of accounting method, or the profitability of other independent projects.

Vanderheiden Inc. is considering two average-risk alternative ways of producing its patented polo shirts. Process S has a cost of $8,000 and will produce net cash flows of $5,000 per year for 2 years. Process L will cost $11,500 and will produce cash flows of $4,000 per year for 4 years. The company has a contract that requires it to produce the shirts for 4 years, but the patent will expire after 4 years, so the shirts will not be produced after 4 years. Inflation is expected to be zero during the next 4 years. If cash inflows occur at the end of each year, and if Vanderheiden's cost of capital is 10 percent, by what amount will the better project increase Vanderheiden's value?

Extending projects with different lives to a common life for comparison purposes, while theoretically appealing, should be done only if there is a high probability that the projects will actually be replicated beyond their initial lives.

The replacement chain, or common life, approach is applicable whether two projects with differing lives are mutually exclusive or independent.