FIN222 Lecture Notes - Lecture 6: Cash Flow, Payback Period, Opportunity Cost

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silverhound358

1 Aug 2018

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Fin222 - review lecture 06: mutually exclusive project = project that compete with one another accept one and exclude the others. Independent project = project that cash flows are not affected by the acceptance or rejection of other projects: cost of return (r) = the minimum return that a capital budgeting project must earn for it to be accepted. Unconventional cash flows = future cash flows include both positive and negative cash flow: 4 investment decision-making tools: a. = difference between pv of an investment"s benefits and pv of its costs. Advantage: correspond directly to the impact of the project on the firm"s value. Disadvantage: relies on an accurate estimate of the discount rate r. + if mutually exclusive, choose one with highest npv. + if independent, accept when npv > 0, reject when npv < 0. Ex: apply npv rule to project requiring mil outlay, returning mil in 1 year when opportunity cost of capital is 7%. b.

Related Questions

Q6) Assume yourself as a financial analyst for the Great Land Company. Then, the director of capital budgeting asks you to analyse two proposed capital investments named Project A and Project B. Each project has a cost of 900,000 birr, and the cost of capital (the required rate of return) for each project is 10%. The information on the projects’ expected net cash flows are as follows with the present value of 1 birr at 10%.

Year	Cash flow of the projects in Birr		PV of 1birr at 10%
Year	Project A	Project B	PV of 1birr at 10%
0	- 900,000	- 900,000	1
1	400,000	245,000	0.909
2	350,000	245,000	0.826
3	250,000	245,000	0.751
4	150,000	245,000	0.683
5	100,000	245,000	0.621

Required:

Calculate each project’s payback period (PBP) and determine which project is preferable as per PBP results. (2 pts)
Calculate each project’s net present value (NPV). (2 Pts)
Determine and justify which project or projects should be accepted as per NPV results if they are independent projects. (2Pts).
Determine and justify which project or projects should be accepted as per NPV if they are mutually exclusive projects. (2Pts).
Calculate the internal rate of return (IRR) for each project and determine whether the projects are accepted or rejected as per IRR result and also determine which project is preferable based on IRR. (2Pts)
Discuss the relative strengths and limitations of the capital budgeting decision criteria that you have used above (Payback period, NPV and IRR).( 3Pts)

goldcoyote821

Gammy is considering building a facility to manufacture cupcakes to distribute nationally. Your assignment involves both the calculation of cash flows associated with the new investment under consideration and the evaluation of several mutually exclusive projects. Grammy wants you to meet with everyone involved and write a meeting report for the board of directors that includes your recommendation. In addition to the recommendation, you have been asked to respond to a number of questions aimed at understanding the capital-budgeting process. Grammy wants to be sure that she and the board of directors understand cash flow and capital budgeting.

We are considering constructing a building to manufacture cupcakes. Currently we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the project:

Cost of new plant and equipment	$7,900,000
Shipping and installation costs	$ 100,000
Unit Sales	Year Units Sold 1 70,000 2 120,000 3 140,000 4 80,000 5 60,000
Sales price per unit	$300/unit in years 1 through 4, $260/unit in year 5
Variable cost per unit	$180/unit
Annual fixed costs	$200,000 per year in years 1 â 5
Working-capital requirements	There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.
The depreciation method	Use the simplified straight-line method over 5 years. Assume the plant and equipment will have no salvage value after 5 years.

5. Answer the following questions:

a. Should you focus on cash flows or accounting profits in making the capital-budgeting decision? Should you be interested in incremental cash flows, incremental profits, total free cash flow, or total profits?

b. How does depreciation affect free cash flow?

c. How do sunk costs affect the determination of cash flows?

d. What is the projectâs initial outlay?

e. What are the differential cash flows over the projectâs life?

f. What is the terminal cash flow?

g. Draw a cash-flow diagram for this project.

h. What is its net present value?

i. What is its internal rate of return?

j. Should the project be accepted? Why or why not?

k. How does Genesis 47: 18 â 19 relate to this project and cash flow management?

Capital budgeting involves choosing projects that add value to the firm. The net present value (NPV), internal rate of return (IRR) and payback period methods are the most common approaches to project selection. At its core, capital budgeting is measuring an accounting of costs versus benefits. In a way, all business decisions are a series of capital budgeting decisions. Get it wrong, and you can destroy a company.

The capital budgeting tools help financial managers decide on the desirability of the projects. In the real world, however, managers sometimes will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods.

For example, consider the two mutually exclusive projects below.

Investments	Cost	Cash Flow 1	Cash Flow 2
Project A	$ 50	$ -	$ 100
Project B	$ 50	$ 50	$ 25

According to the payback period, project B should be selected. Although both projects cost the same, project B has a payback period of one period, while project A will payback in roughly 1.5 periods.

Assuming the discount rate of 5%, NPV(A) = $41 and NPV(B) = $20.

This example illustrates the limitations of the payback period method. Even though the payback period method points to project B, the NPV method points to project A since it has more than twice the NPV value to that of project B. Yet the manager may choose project A. Why?

It may be that the project stakeholder is requesting a quicker return in cash.

For this discussion, create an example problem where two (or more) methods contradict each other. What would be the "appropriate" choice (which project would you choose)? In what cases would you not choose the "best" choice?

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FIN222 Lecture Notes - Lecture 6: Cash Flow, Payback Period, Opportunity Cost

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