BFF2140 Business Finance

Tutorial Week 04 - Worksheet

WEEK 4 CAPITAL BUDGETING I: TECHNIQUES FOR EVALUATION

Reminders:

● Post-class Online Exercise 2 is due on Friday at 11:55PM this week (Week 4).
Please pay attention to the instructions, particularly rounding and units.
MyFinanceLab platform is sensitive to the format in which you enter your
answer. You are allowed three attempts per question (not per sub-part of a
question), and the highest mark counts. Make sure you submit the online
exercise before it is due. Note that special consideration will only be granted if
you have evidence of exceptional circumstances, such as a medical certificate,
covering the entire duration (including weekends) that the online exercise is
live, or screenshots of a prolonged technical incident on Moodle (if any).
Special consideration must be submitted within two business days after the
exercise is closed.

● Have you read the relevant chapters of the prescribed textbook and completed
all asynchronous activities on Moodle prior to attending this tutorial?

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Activity 1: Instructor-led discussion - Describing the context

To achieve the ultimate objective of shareholders’ value maximisation, the corporate

manager needs to make three key decisions in which investment (or capital
budgeting) decision is the most important one. Capital budgeting is used by
companies to evaluate major long-term investments, such as new plants, machines
or equipment. It involves analysing the project's cash inflows and outflows to
determine whether a set benchmark is met.

The main evaluation techniques (tools) for capital budgeting projects include the
payback period (PB), internal rate of return (IRR) and net present value (NPV). In
complex situations when these main techniques fail to provide an optimal decision,
other techniques such as the profitability index (PI) and equivalent annual annuity
(EAA) methods can be useful. Each of these evaluation techniques have different
criterias for an optimal decision to be made. What are the criterias for each of these
evaluation techniques? What are the different types of projects? Will different types
of projects result in different decisions being made? If yes, how do they differ?

In this activity, your instructor will lead you through the discussion about the decision
criteria of each technique under different types of projects.

Discussion note:

● Activity 1 completion

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Activity 2: Interactive Session - Concept Check

Your instructor will release a few multiple choice questions regarding week four
materials.

Provide your responses to the Flux polling system shared by your tutor. You are
encouraged to keep a copy of your response alongside with other discussion notes
below for your own reference.

1. Which of the following statements is FALSE?

a. Payback period refers to the number of periods take to recover the initial
investment of a project.
b. The payback rule is reliable because it considers the time value of money and
depends on the cost of capital.
c. The payback rule is primarily used because of its simplicity.
d. The payback rule is useful in cases where the cost of making an incorrect
decision might not be large enough to justify the time required for calculating
the NPV.

2. The NPV profile graphs:

a. the project's NPV over a range of discount rates.
b. the project's IRR over a range of discount rates.
c. the project's cash flows over a range of NPVs.
d. the project's IRR over a range of NPVs.

3. Which of the following statements is FALSE?

a. The IRR investment rule states you should turn down any investment
opportunity where the IRR is less than the opportunity cost of capital.
b. In a standalone project (independent project), the decision made by applying
NPV investment rule is usually consistent with that of IRR investment rule.
c. Since the IRR rule is based upon the rate at which the NPV equals zero, like
the NPV decision rule, the IRR decision rule will always identify the correct
investment decisions.
d. There are situations in which multiple IRRs exist.

4. Which of the following statements is FALSE?

a. The profitability index measures the value created in terms of NPV per unit of
resource consumed.
b. Capital rationing is the process through which companies decide how to
allocate their capital among different projects, given that their resources are
not limitless.
c. The profitability index can be easily adapted for determining the correct
investment decisions when multiple resource constraints exist.

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 d. If there is a fixed supply of resources available, so that you cannot undertake
all possible opportunities, then simply picking the highest NPV opportunity
might not lead to the best decision.

5. When comparing two projects with different lives, why do you compute an annuity
(known as Equivalent Annual Annuity, EAA) with an equivalent present value
(PV) to the net present value (NPV)?
a. so that you can see which project has the greatest net present value (NPV)
b. so that the projects can be compared based on their cost or value created per
period
c. to reduce the danger that changes in the estimate of the discount rate will lead
to choosing the project with a shorter timeframe
d. to ensure that cash flows from the project with a longer life that occur after the
project with the shorter life has ended are considered

Discussion note:

● Activity 2 completion

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Activity 3: Individual activity - Solving problems using formulae &
computational aids

Instruction: This activity contains a few capital budgeting problems. You are required
to solve them using formula and computational aids. Work individually for the next 15
minutes to solve the following problems in this tutorial worksheet. You are
encouraged to demonstrate your workings which include
● drawing a timeline on a paper,
● choosing a correct formula,
● applying correct numbers in the formula, and
● calculating the final answer using your chosen computational aid.

Question 1:

Investment A

Year 0 1 2 3 4 5

Cash flow -$15,000 $7,000 $7,000 $7,000 $7,000 $7,000

Investment B

Year 0 1 2 3 4 5

Cash flow -$18,000 $12,000 $2,000 $2,000 $2,000 $2,000

The cash flows for two projects are shown above. The cost of capital is 9.5%. If an
investor decided to take projects with a payback period two years or less, which of
these projects would he take?

Answer:

[Type your answer here]

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Question 2:

Burke Inc. is considering the purchase of Small Ltd. The acquisition would cost
$190,000 but would increase Burke’s cash flows by $30,000 per year for the
foreseeable future. If Burke’s cost of capital is 15%, should it go ahead with the
acquisition of Small?

Answer:

[Type your answer here]

Question 3:

A development project involves purchasing a home and land for $15 million. In
addition, the local council insists on a $4 million fee for defacing the views from the
city. It also costs $1 million to lease the relevant equipment to conduct the project.

This project provides a series of cash flows in the following table. You believe the
project is very risky and therefore decided to use a discount rate of 23%. Calculate
the Net Present Value (NPV) and the Internal Rate of Return (IRR). Would your
decision change if you used a discount rate of 10%?

Projected Cash
flow Projected Cash flow

Year 1 $1,500,000 Year 11 $2,500,000

Year 2 $3,278,000 Year 12 $2,500,000

Year 3 $5,000,000 Year 13 $2,500,000

Year 4 $6,450,000 Year 14 $2,500,000

Year 5 $2,500,000 Year 15 $2,500,000

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 Year 6 $2,500,000 Year 16 $2,500,000

Year 7 $2,500,000 Year 17 $2,500,000

Year 8 $2,500,000 Year 18 $2,500,000

Year 9 $2,500,000 Year 19 $2,500,000

Year 10 $2,500,000 Year 20 $2,500,000

Answer:

[Type your answer here]

Question 4:

Initial investment Annual Cash flow

Project A $35 million $14 million

Project B $19 million $7 million

Project C $15 million $7 million

Project D $20 million $10.5 million

An investor has a budget of $35 million. He can invest in the 4-year projects shown
above. If the cost of capital is 8%, what investment(s) should he make?

Answer:

[Type your answer here]

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Question 5:

Billy was asked to choose between the following mutually exclusive projects:

Expected Net Cash Flows

Year Project S Project L
0 ($100,000) ($100,000)
1 60,000 33,500
2 60,000 33,500
3 33,500
4 33,500

The projects provide a necessary service, so whichever one is selected is expected

to be repeated into the foreseeable future. Both projects have a 10 percent cost of
capital.

Required:

A. What is each project’s initial NPV without replication (naive NPV rule)?
B. Repeat the analysis assuming now replication takes place. Hint: Use the
equivalent annual annuity approach and lowest common multiple methods
introduced in class.

Answer:

[Type your answer here]

Discussion Note:

● Activity 3 completion

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Activity 4: Group activity - Solving a complex problem

Instruction: This activity contains a challenging and complex problem in which you
will be working in groups. You are encouraged to demonstrate your workings which
include
● drawing a timeline on a paper,
● choosing a correct formula,
● applying correct numbers in the formula, and
● calculating the final answer using your chosen computational aid.

Question 6:

Taylor Made Inc. is considering two mutually exclusive projects. The projects’
expected net cash flows are provided in the table below.

YEAR PROJECT 1 PROJECT 2

0 ($300,000) ($599,000)
1 (387,000) 234,000
2 (193,000) 234,000
3 100,000 234,000
4 600,000 234,000
5 1,270,000 234,000

A. Sketch (with a pen on a paper) the NPV profiles for projects A and B. Be
careful to ensure that you label all axes, lines and points carefully.

B. If you were told that each project’s cost of capital is 10%, which project should
be selected? You are required to calculate the NPV for each project to receive
full credit.

C. Calculate the crossover rate exactly? Explain in one or two sentences the
importance of the crossover rate. Specifically in your answer detail the range
for cost of capital that project 1 would be preferable to project 2?

Answer:

[Type your answer here]

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Question 7:

Chloe reportedly was paid a $11 million advance to write a book. The book took one
year to write. In the time she spent writing, she could have been paid to give
speeches and appear on TV news as a political commentator. Given her popularity,
assume that she could have earned $8 million over the year (paid at the end of the
year) she spent writing the book.

Assume that once her book is finished, it is expected to immediately generate

royalties of $5 million in the first year (paid at the end of the year) and these royalties
are expected to decrease by 40% per year in perpetuity. Assuming that Chloe's cost
of capital is 10% and given these royalties payments, what is the NPV of Chloe's
book deal?

Answer:

[Type your answer here]

Discussion note:

● Activity 4 completion

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Activity 5: Case-study - Creating NPV profiles using Excel

In this activity, you’ll be working in groups for the next 30 minutes to analyse the
sensitivity of the project NPV to changes in the project’s cost of capital, by
constructing NPV profiles using Excel.

Constructing NPV profiles is an essential skill set within Finance, because NPV
profiles are frequently used in the workplace by the project evaluation team.

Case scenario

You work as an analyst in a team led by the Chief Financial Officer (CFO) of Chadstone Ltd
and you support the executive management team by offering insights and financial advice
that will allow the team to make the best business decisions for the company.

Presented on the discussion desk are the proposals of two mutually exclusive projects, in
which you are tasked with justifying the choice between these projects. The cash flows of
these projects are provided in the table below in an environment of changing interest rates.
The manager would like to point out how changes in interest rates could affect the decision.
The cost of capital is 12%, and the figures presented in the table below are in millions.

As you learnt from corporate finance unit, a NPV profile shows the sensitivity of a project’s
NPV for different discount rates and it is plotted on a graph where NPVs are on the y-axis
with the discount rates on the x-axis, you know that plotting the NPV profile can help make
such capital budgeting decision (i.e., choosing the better project to invest in).

Required:

● Calculate the NPV and IRR of both projects using Excel syntax. Make sure the excel
formula used is dynamic (i.e., outcome can be changed easily by changing the input
cells).
● With an increment of 1% for discount rate, construct a dynamic NPV profile for both
of the projects, and briefly describe the process.
● Determine if both projects cross-over. If yes, calculate the crossover rate, and provide
the range of discount rates where NPV and IRR decisions will conflict.
● With the current cost of capital, provide your recommendation on which of the
projects should be undertaken. In your recommendation, provide the range of
discount rates that your decision will remain valid.

Present all your analysis in an excel document. Your tutor may randomly choose one or two
groups to present their analysis.

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Discussion note:

● Activity 5 completion

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Activity 6: Feedback and Wrap up

Instruction: Provide feedback through the online polling system. Your feedback is
important to us.

Discussion note:

● Activity 6 completion

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