Capital Investments quiz

There are many factors that can affect the stock price, including whether Ms. Ndereba’s analysis indicates that the project is more or less profitable than investors expected .

Going concern projects are those to maintain the business or to increase the efficiency of existing operations. The other two projects are business growth investments that increase the size of the company .

The projects are independent, meaning that either one or both projects may be chosen. Both projects have positive NPVs, therefore both projects add to shareholder wealth and both projects should be accepted.

CF0 = – 4,662,005  ; CF1 = 22,610,723  ; CF2 = ‒ 41,072,261  ; CF3 = 33,116,550  ;CF4 = ‒ 10,000,000  ;  I = 8  ; CPT NPV = ‒ 307.7589

CF0 = – 4,662,005  ; CF1 = 22,610,723  ; CF2 = ‒ 41,072,261  ; CF3 = 33,116,550  ;CF4 = ‒ 10,000,000  ;  I = 15  ; CPT NPV = 99.9354

CF0 = – 4,662,005  ; CF1 = 22,610,723  ; CF2 = ‒ 41,072,261  ; CF3 = 33,116,550  ;CF4 = ‒ 10,000,000  ;  I = 8  ; CPT NPV = ‒ 0.0120

Costs to finance the investment are taken into account when the cash flows are discounted at the appropriate COC; including interest costs in the cash flows would result in double-counting the cost of debt .

Rescheduling and prioritizing projects is part of the planning stage of the capital budgeting process, not the post-audit. The post-audit’s purpose is to explain any differences between the actual and predicted results of a capital budgeting project. This process can aid in indicating systematic errors, improve business operations, and provide concrete ideas for future investment opportunities.

Using a financial calculator or the trial and error method, the IRR is 28.79%. The COC, which is stated as 10%, is not used to solve the problem.

2	1	0	Year
120,000	100,000	150,000 -	Cash flow

Using a financial calculator:

Cf0 = -150,000 ;C01 = 100,000 ; C02 = 120,000 ; CPT IRR = 28.7855

Arranging financing is not one of the administrative steps in the capital budgeting process. The four administrative steps in the capital budgeting process are:

1. Idea generation

2. Analyzing project proposals

3. Creating the firm-wide capital budget

4. Monitoring decisions and conducting a post-audit

Mandatory regulatory or environmental projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. The projects typically generate little to no revenue, but they accompany other new revenue producing projects and are accepted by the company in order to continue operating .

Cf0 = -775,000 , C01 = 0, F01 = 1,  C02 = 300,000, F02 = 2,  C03 = 400,000, F03 = 1;  IRR = 8.6534

or

Cf0 = -775,000 , C01 = 0,  C02 = 300,000,  C03 = 300,000, C04 = 400,000 ;  IRR = 8.6534

CFO = -100,000;  CF1 = 10,000;  CF2 = 15,000;  CF3 = 138,000;  I = 12; CPT→NPV = $19,112.

The NPV sums the investment’s expected cash flows (CF) discounted at the opportunity COC. The NPV calculation is

where

CFt= the expected net cash flow at timet

N= the investment’s projected life

r= the discount rate or opportunity COC

Key principles of the capital allocation process are :

1. Decisions are based on cash flows, not accounting income .

2. Cash flows are based on opportunity costs .

3. The timing of cash flows is important .

4. Cash flows are analyzed on an after-tax basis .

5. Financing costs are reflected in the project's required rate of return .

Project P ⇒ N = 5; PMT = 5,000; FV = 0; I/Y = 12; CPT→PV = 18,024;  NPV for Project A = 18,024 – 15,000 = 3,024.
Project Q ⇒ N = 5; PMT = 7,500; FV = 0; I/Y = 12; CPT→PV = 27,036;  NPV for Project B = 27,036 – 25,000 = 2,036.

For independent projects the NPV decision rule is to accept all projects with a positive NPV. Therefore, accept both projects.

or

Project P  ⇒ Cf0 = -15,000, C01 = 5,000, F01 = 5,  I = 12 ;  CPT NPV = 3,024.

Project Q  ⇒ Cf0 = -25,000, C01 = 7,500, F01 = 5,  I = 12 ;  CPT NPV = 2,036.

Since the sale was not anticipated by the market, the share price should rise by the NPV of the project per common share. NPV is already calculated using after-tax cash flows.

The IRR is the discount rate that makes the NPV = 0. Because the cash flow stream is in perpetuity, it can be solved as follows:

0 = –270 + (30/IRR)

IRR = 11.1%

In theory, a positive NPV project should provide an increase in the value of a firm's shares.

NPV of new capital equipment = $50 million - $30 million = $20 million

Value of company prior to equipment purchase = 8,000,000 × $28.00 = $224,000,000

Value of company after new equipment project = $224 million + $20 million = $244 million

Price per share after new equipment project = $244 million / 8 million = $30.50

Note that in reality, changes in stock prices result from changes in expectations more than changes in NPV.

Expansion projects increase the scale of a firm’s existing activities and/or extend a firm’s reach into new product or service categories and markets, in the hopes of generating longer-term expected gains. Regulatory/compliance projects are required for the business to continue operations but otherwise might not be undertaken by a company. Going concern projects benefit the company through improved efficiencies and cost savings over time .

Using either the IRR function in Excel or a financial calculator, IRR is determined by setting the NPV equal to zero for the cash flows shown in the following table

3	2	1	0	Year
900	200	200	- 1,000	Cash flow (GBP)

CFO = -1,000; CF1 = 200; CF2 = 200; CF3 = 900;  CPT→  IRR = 11.0258

Sunk costs are not to be included in investment analysis. Opportunity costs and the project's impact on taxes are relevant variables in determining project cash flow for a capital investment.

Introducing a new product or entering a new market involves sales and expense projections that can be highly uncertain, and therefore require the greatest degree of detailed analysis. Addressing safety or regulatory concerns or replacing old machinery typically involve less uncertainty and do not require the same depth of analysis as developing a new product or entering a new market .

The key is first identifying this as a NPV problem. The minimum price the company should accept for selling the property is the net present value of the mine if the company built and operated it.

Next, the year of each cash flow must be property identified; specifically: CF0= –430,000 ; CF1-7= +$200,000 ; CF8= –$170,000.

Entering these values into the cash flow worksheet:

CF0= –430,000 ; C01 = 200,000; F01 = 7 ; C02 = –170,000 ; F02 = 1 ; I = 16 ; CPT NPV = 325,858.76

Project X

CF0 = – 15,000 ; CF1 = 2,000 ;  CF2 = 5,000 ; CF3 = 8,000 ; CF4 = 8,000 ; I = 15 ; CPT NPV = 354.0046

IRR= 16 % (given)

Project Y

CF0 = – 13,250 ; CF1 = 200 ;  CF2 = 500 ; CF3 = 7,000 ; CF4 = 15,000 ; I = 15 ; CPT NPV = 480.8972

CF0 = – 13,250 ; CF1 = 200 ;  CF2 = 500 ; CF3 = 7,000 ; CF4 = 15,000 ;  CPT IRR = 16.1542

Because these projects are mutually exclusive, only one can be undertaken: It should be Project Y, which has the highest NPV and thus increases shareholder wealth the most. Both projects’ IRRs exceed the hurdle rate, and the IRR of Project Y exceeds that of Project X. The decision, however, should be based on the superior NPV of Project Y

(Both projects ) is incorrect. Both NPV_X and NPV_Y are positive, but because they are mutually exclusive projects, only the one with higher positive NPV will be chosen

CF0= – $336,875

CF1= $100,000

CF2 = $ 82,000

CF3 = $ 76,000

CF4 = $ 111,000

CF5 = $ 142,000

 I= 8

 CPT→ NPV =  $64,582

or

To determine the net present value of the investment, given the required rate of return, we can discount each cash flow to its present value, sum the present value, and subtract the required investment.

PV of Cash flow at 8%	Cash Flow	Year
– 336,875.00	– 336,875.00	0
92,592.59	100,000.00	1
70,301.78	82,000.00	2
60,331.25	76,000.00	3
81,588.31	111,000.00	4
96,642.81	142,000.00	5
64,581.74	Net Present Value

A post-audit identifies what went right and what went wrong. It is used to improve forecasting and operations .

The project should be accepted on the basis of its positive NPV and its IRR, which exceeds the cost of capital.

When valuing mutually exclusive investments, the decision should be made with the NPV method because this method uses the most realistic discount rate—namely, the opportunity cost of funds. In this example, the reinvestment rate for the NPV method (here, 10%) is more realistic than the reinvestment rate for the IRR method (here, 21.86% or 18.92%) .

Stock prices reflect investor expectations for future investment and growth. A new positive-NPV project will increase stock price only if it was not previously anticipated by investors .

In valuing investments, expected cash flows should be discounted at required rates of return that reflect their risk, not at a risk-free rate that ignores risk. NPV is superior to IRR. Choosing projects based on IRR might cause the company to concentrate on short-term investments that do not maximize the company’s NPV .

CF0= – $28,000 ; CF1= $7,000 ; F1= 4 ; CF2= $6,000 ; F2= 2 ; CPT→IRR = 11.6175% .