The purpose of this assignment is to solidify your understanding on the capital budgeting

1

Assignment #4

The purpose of this assignment is to solidify your understanding on the capital budgeting

techniques (mainly Net Present Value and Internal Rate of Return). The scores of this

assignment will help in assessing the following learning goal of the course: “students

successfully completing this course will be able to apply capital budgeting techniques to evaluate

long term investment decisions of firm.

Instructions:

You are required to use a financial calculator or spreadsheet (Excel) to solve the following

capital budgeting problem (sample questions and solutions are provided for guidance):

Kingston Corp. is considering a new machine that requires an initial investment of $520,000

installed, and has a useful life of 8 years. The expected annual after-tax cash flows for the

machine are $76,000 during the first 3 years, $87,000 during years 4 through 6 and $92,000

during the last two years.

(i) Develop the timeline (linear representation of the timing of cash flows)

(ii) Calculate the Internal Rate of Return (IRR)

(iii) Calculate the Net Present Value (NPV) at the following required rates of return:

(a) 3% (b) 4% (c) 8% (d) 9%

(iv) Using IRR and NPV criterion, comment if the project should be accepted or rejected

at the following required rates of return:

(a) 3% (b) 4% (c) 8% (d) 9%

(v) Plot the Net Present Value profile (NPV on Y axis and rates of return on X-axis).

3

Sample Question and Solution

Question:

Your firm is considering an investment that will cost $1.5 million today today. The project will produce cash flows of $350,000 in year 1, $390,000 in years 2 through 4, and $450,000 in year 5.

(i) Develop the timeline (linear representation of the timing of cash flows)

(ii) Calculate the Internal Rate of Return (IRR)

(iii) Calculate the Net Present Value (NPV) at the following required rates of return:

(a) 7% (b) 8% (c) 10% (d) 12%

(iv) Using IRR and NPV criterion, comment if the project should be accepted or rejected at

the following required rates of return:

(a) 7% (b) 8% (c) 10% (d) 12%

(v) Plot the Net Present Value profile (NPV on Y axis and rates of return on X-axis).

Solution:

(i) Timeline

Years 0 1 2 3 4 5 Cash Flows -1,500,000 350,000 390,000 390,000 390,000 450,000

(ii) IRR: 9.48%

(iii) (a) NPV at 7% : $104,473 (a) NPV at 8%: $60,955 (b) NPV at 10%: ($20,702) (c) NPV at 12%: ($95,806)

(iv) (a) At required rate of return of 7%, accept the project since IRR > 7% and NPV > 0

(b) At required rate of return of 8%, accept the project since IRR > 8% and NPV > 0 (c) At required rate of return of 10%, reject the project since IRR <10% and NPV <0 (d) At required rate of return of 12%, reject the project since IRR <12% and NPV <0

4

(v) NPV Profile:

NPV Profile 150,000 100,000

50,000

0% 2% 4% 6% 8% 10% 12% 14%

-50,000 -100,000 -150,000

Required Rates of Return

N et

P re

se nt

V al

ue s (

$)