FIN 305 Study Guide - Final Guide: British Rail Class 55, Net Present Value, Capital Budgeting
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Seth Bullock, the owner of Bullock Gold Mining, is evaluating a new gold mine in South Dakota. Dan Dority, the companyâs geologist, has just finished his analysis of the mine site. He has estimated that the mine would be productive for eight years, after which the gold would be completely mined. Dan has taken an estimate of the gold deposits to Alma Garrett, the companyâs financial officer.
Alma has been asked by Seth to perform an analysis of the new mine and present her recommendation on whether the company should open the new mine. Alma has used the estimates provided by Dan to determine the revenues that could be expected from the mine. She has also projected the expense of opening the mine and the annual operating expenses. If the company opens the mine, it will cost $525 million today, and it will have a cash outflow of $35 million nine years from today in costs associated with closing the mine and reclaiming the area surrounding it. The expected cash flows each year from the mine are shown in the table.
Bullock Mining has a required return of 12 percent on all of its gold mines.
| Provided Table below | |
| Year | Cash Flow |
| 0 | -$525,000,000 |
| 1 | $74,000,000 |
| 2 | $97,000,000 |
| 3 | $125,000,000 |
| 4 | $157,000,000 |
| 5 | $185,000,000 |
| 6 | $145,000,000 |
| 7 | $125,000,000 |
| 8 | $102,000,000 |
| 9 | -$35,000,000 |
Required Return: 12%
1. What type of cash flow are these for the proposed mine for Bullock Gold Mining above? Conventional or non-conventional? If non-conventional, explain what issues will occur with IRR rule
2. Calculate the Payback period below. If Bullock Gold Mining payback limit is 4 years, would they accept or reject this independent project based on Payback Period rule?
| Year | Cash Flow | 1st Calculate Cumulative Cash Flows | NOTES to calculate 1st each row: | 2nd Calculate Payback Period (see answer below): | |||||
| 0 | -$525,000,000 | ||||||||
| 1 | $74,000,000 | ||||||||
| 2 | $97,000,000 | ||||||||
| 3 | $125,000,000 | ||||||||
| 4 | $157,000,000 | ||||||||
| 5 | $185,000,000 | ||||||||
| 6 | $145,000,000 | ||||||||
| 7 | $125,000,000 | ||||||||
| 8 | $102,000,000 | ||||||||
| 9 | -$35,000,000 | ||||||||
3. Calculate the net present value (NPV) of the proposed mine for Bullock Gold Mining below. Would they accept or reject this independent project based on NPV rule? Note: required return is 12%.
| R/I% | NPV result calc/input$ below |
| 12% |
4. Calculate the internal rate of return (IRR) of the proposed mine for Bullock Gold Mining below. Would they accept or reject this independent project based on IRR rule? (Answer carefully based on answer to question 1 above). Note: required return is 12%.
| R/I% | IRR result calc/input% below |
| 12% |
5. Based on your analysis, should the company open the mine? Which of the Investment Criteria calculated above (Payback, NPV and IRR) should Bullock Gold Mining use as their decision factor, and why?
Your first assignment in your new position as assistant financial analyst at Caledonia Products is to evaluate two new capital-budgeting proposals. Because this is your first assignment, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at assessing your understanding of the capital-budgeting process. This is a standard procedure for all new financial analysts at Caledonia, and it will serve to determine whether you are moved directly into the capital-budgeting analysis department or are provided with remedial training. The memorandum you received outlining your assignment follows:
To: The New Financial Analysts
From: Mr. V. Morrison, CEO, Caledonia Products
Re: Capital-Budgeting Analysis
Provide an evaluation of two proposed projects, both with 5-year expected lives and identical initial outlays of
$110,000. Both of these projects involve additions to Caledoniaâs highly successful Avalon product line, and as
a result, the required rate of return on both projects has been established at 12 percent. The expected free cash
flows from each project are as follows:
| Project A | Project B | ||
| Initial outlay | -$110,000 | -$110,000 | |
| Inflow year 1 | 20,000 | 40,000 | |
| Inflow year 2 | 30,000 | 40,000 | |
| Inflow year 3 | 40,000 | 40,000 | |
| Inflow year 4 | 50,000 | 40,000 | |
| Inflow year 5 | 70,000 | 40,000 |
In evaluating these projects, please respond to the following questions. For questions from (a) to (j) assume that the projects are independent. That is both could be accepted if both are acceptable.
a. What is the payback period on each project? If Caledonia imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?
b. What are the criticisms of the payback period?
c. Determine the NPV for each of these projects. Should they be accepted?
d. Describe the logic behind the NPV.
e. Determine the PI for each of these projects. Should they be accepted?
f. Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
g. Determine the IRR for each project. Should they be accepted?
h. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?
i. Determine the MIRR for each project. Should they be accepted?
j. Describe the logic behind the MIRR.
k. Rank the two project based on all above criteria and make a recommendation as to which (if either) should be
accepted under the assumption that the projects are mutually exclusive.
l. Caledonia is considering two additional mutually exclusive projects. The free cash flows associated with these projects are as follows:
| Project A | Project B | ||
| Initial outlay | -$100,000 | -$100,000 | |
| Inflow year 1 | 32,000 | 0 | |
| Inflow year 2 | 32,000 | 0 | |
| Inflow year 3 | 32,000 | 0 | |
| Inflow year 4 | 32,000 | 0 | |
| Inflow year 5 | 32,000 | 200,000 |
The required rate of return on these projects is 11 percent.
1. What is each projectâs payback period?
2. What is each projectâs NPV?
3. What is each projectâs IRR?
4. What has caused the ranking conflict?
5. Which project should be accepted? Why?
I ONLY NEED TO DO PART l. (the last question) I need to answer questions 1-5
