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Egret Printing and Publishing Company is a family owned speciality printing business. It was
founded by John and Keith Belford in 1956 after they were discharged from the US Army.
Patrick Hill who is the son in law of Keith Belford joined the firm in 1979 in the Accounting
Department. He was promoted as a treasurer in 1988 and then as the Vice-President of Finance
in 1994. His main responsibility was to look after both, the internal and external financial
operations, but more importantly the internal ones. John and Keith Belford are said to possess
nature that is of extreme conservatism and this was due to the fact that their father had suffered a
great deal under a crushing burden of debt during the Great Depression of the 1930s.And it was
because of this that the Belford brothers vowed never to get deeply into debt.
However, Hill currently is busy carrying out a detailed analysis of four major capital investment
proposals that the Belfords have identified as possible candidates for funding in the coming
year. A description of each of the four projects is also given that includes information such as the
costs and expected after-tax cash flows(net income plus depreciation).All of the four projects are
considered to be equally risky and their risk is about the same as that of the companys other
assets.
to a computer typesetter and printing press. The expansion would also make it possible to carry
out various jobs simultaneously.
the past for internal funds. Under the existing all-equity capital structure, any additional funds
employed in the business will have to come from the Belford Brothers. For them to make these
funds available personal security holdings will have to be liquidated.
However, Hill has been working on to change the firms policy by introducing the use of debt to
complete the current analysis which in turn would lower the cost-of-capital. He wishes to be able
to explain the advantages of debt financing to the Belford Brothers and also show them the effect
of a change in the capital structure on the capital budget. He has also talked about this with the
companys bankers who have told him that the company can borrow $500,000 at an interest rate
of 12% and reduce the weighted average cost of capital from the present 15%. The tax rate used
by the company is 46%.After discussing about the issue with the Belford brothers Hill concluded
that their opportunity cost on outside investment is 21%, while the cost of internal funds is 15%
only. Hill is also working on a five year financial plan for the company, developing estimates of
capital investment opportunities and financing sources for this period. However since the plan is
at its initial stage so he cannot formally incorporate it into the capital budgeting
recommendations for the current year. But he is confident about the fact that he will be
successful in persuading the Belford brothers to use a small amount of debt financing which will
lower the cost of capital and also that the recently initiated employee incentive program which is
designed to generate new project ideas will bear fruit with the result that Egret Printing and
Publishing company will be able to invest more money at higher rates of return in the future than
it has been able to generate in the past.
a) Ordinary Payback Period
It is calculated using formula,
Payback period= year before recovered + remaining amount to recover
Recovered year cash flow
Or
Initial investment
Annual cash flow
Project A
Cash Flows
Original
Investment
Year 1
Year 2
Year 3
Year 4
cumulative
flow
cash
-500,000
136,000
136,000
136,000
618,800
136,000
272,000
408,000
1,026,800
-364,000
-228,000
-92,000
526,800
Project B
year
Cash Flows
Original
Investment
Year 1
Year 2
Year 3
Year 4
-500,000
370,000
270,000
155,000
49,000
cumulative
flow
cash Cumulative
Flows
Cash
-500,000
370,000
640,000
795,000
844,000
-130,000
140,000
295,000
344,000
Project C
year
Cash
Flows
Original Investment
1,000,000
323,000
323,000
323,000
323,000
Year 1
Year 2
Year 3
Year 4
cumulative
flow
cash Cumulative
Flows
-1,000,000
323,000
646,000
969,000
1,292,000
-677,000
-354,000
-31,000
292,000
Cash
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
323,000
323,000
323,000
323,000
323,000
323,000
1,615,000
1,938,000
2,261,000
2,584,000
2,907,000
3,230,000
615,000
938,000
1,261,000
1,584,000
1,907,000
2,230,000
year
Cash Flows
Initial investment
-500,000
Year 1
Year 2
Year 3
Year 4
Year 5
175,000
175,000
175,000
175,000
175,000
175,000
350,000
525,000
700,000
875,000
-325,000
-150,000
25,000
200,000
375,000
1.5
1
0.5
0
A
Year
Cash Flows
PVIF@15%
PV
Cumulative
CFs
0
1
2
3
4
-500,000
136,000
136,000
136,000
618,800
1
0.8696
0.7561
0.6575
0.5718
-500,000
118,266
102,830
89,420
353,829.84
-500,000
-381,734
-278,905
-189,485
164,345.04
Year
Cash Flows
PVIF@21%
PV
Cumulative
CFs
0
1
2
3
4
-500,000
136,000
136,000
136,000
618,800
1
0.8264
0.683
0.5645
0.4665
-500,000
112,390
92,888
76,772
288,670.20
-500,000
-387,610
-294,722
-217,950
70,720.60
Year
Cash Flows
PVIF@15%
PV
Cumulative
CFs
0
1
2
3
4
-500,000
370,000
270,000
155,000
49,000
1
0.8696
0.7561
0.6575
0.5712
-500,000
321,752
204,147
101,913
27,989
-500,000
-178,248
25,899
127,812
155,800
Year
Cash Flows
PVIF@21%
PV
Cumulative
CFs
0
1
2
3
4
-500,000
370,000
270,000
155,000
49,000
1
0.8264
0.683
0.5645
0.4665
-500,000
305,768
184,410
87,498
22,859
-500,000
-194,232
-9,822
77,676
100,534
Year
Cash Flows
PVIF@15%
PV
Cumulative
CFs
0
1
2
3
4
5
6
7
8
9
10
-1,000,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
1
0.8696
0.7561
0.6575
0.5718
0.4972
0.4323
0.3759
0.3269
0.2843
0.2472
-1,000,000
280,881
244,220
212,373
184,691
160,596
139,633
121,416
105,589
91,829
79,846
-1,000,000
-719,119
-474,899
-262,526
-77,835
82,761
222,394
343,809
449,398
541,227
621,072
Year
Cash Flows
PVIF@21%
PV
Cumulative
CFs
-1,000,000
-1,000,000
1
2
3
4
5
6
323,000
323,000
323,000
323,000
323,000
323,000
0.8264
0.683
0.5645
0.4665
0.3855
0.3186
1,000,000
266,927
220,609
182,334
150,680
124,517
102,908
-733,073
-512,464
-330,130
-179,451
-54,934
47,974
7
8
9
10
323,000
323,000
323,000
323,000
0.2633
0.2176
0.1799
0.1486
85,046
70,285
58,108
47,998
133,019
203,304
261,412
309,410
Year
Cash Flows
PVIF@15%
PV
Cumulative
CFs
0
1
2
3
4
5
-500,000
175,000
175,000
175,000
175,000
175,000
1
0.8696
0.7561
0.6575
0.5718
0.4972
-500,000
152,180
132,318
115,063
100,065
87,010
-500,000
-347,820
-215,503
-100,440
-375
86,635
Year
Cash Flows
PVIF@21%
PV
Cumulative
CFs
0
1
2
3
4
5
-500,000
175,000
175,000
175,000
175,000
175,000
1
0.826
0.683
0.565
0.467
0.386
-500,000
144,550
119,525
98,875
81,725
67,550
-500,000
-355,450
-235,925
-137,050
-55,325
12,225
Discounted payback
period@15%
2
1
0
A
Discounted payback
period@21%
2
1
0
A
Year
Cash Flows
1
136,000
2
136,000
3
136,000
4
618,800
Total present value
Initial investment
Net present value
PVIF@15%
0.8696
0.7561
0.6575
0.5718
PV
118,266
102,830
89,420
353,830
664,345.04
-500,000.00
164,345.04
Year
Cash
Flows
136,000
136,000
136,000
618,800
PVIF@21%
PV
0.8264
0.683
0.5645
0.4665
112,390
92,888
76,772
288,670.20
570,720.60
500,000.00
70,720.60
Cash
Flows
370,000
270,000
155,000
49,000
PVIF@15%
PV
0.8696
0.7561
0.6575
0.5718
321,752
204,147
101,913
28,018.20
655,829.70
500,000.00
1
2
3
4
Total present value
Initial investment
Net present value
Project B
Year
1
2
3
4
Total present value
Initial investment
155,829.70
Cash
Flows
370,000
270,000
155,000
49,000
PVIF@21%
PV
0.8264
0.683
0.5645
0.4665
305,768
184,410
87,498
22,858.50
600,534.00
500,000.00
100,534.00
Year
Cash
Flows
PVIF@15%
PV
323,000
0.8696
280,881
323,000
0.7561
244,220
323,000
0.6575
212,373
4
323,000
5
323,000
6
323,000
7
323,000
8
323,000
9
323,000
10
323,000
Total present value
Initial investment
Net present value
0.5718
0.4972
0.4323
0.3759
0.3269
0.2843
0.2472
184,691
160,596
139,633
121,416
105,589
91,829
79,846
1,621,072
1,000,000
621,072
Year
1
2
3
4
Total present value
Initial investment
Net present value
Project C
Year
1
2
3
4
5
6
7
8
9
10
Total present value
Initial investment
Net present value
Cash
Flows
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
PVIF@21%
PV
0.8264
0.683
0.5645
0.4665
0.3855
0.3186
0.2633
0.2176
0.1799
0.1486
266,927
220,609
182,334
150,680
124,517
102,908
85,046
70,285
58,108
47,998
1,309,410
1,000,000
309,410
Cash
Flows
175,000
175,000
175,000
175,000
175,000
PVIF@15%
PV
0.8696
0.7561
0.6575
0.5718
0.4972
152,180
132,318
115,063
100,065.00
87,010.00
586,635.00
500,000.00
86,635.00
Cash
Flows
175,000
175,000
175,000
175,000
PVIF@21%
PV
0.8264
0.683
0.5645
0.4665
144,620
119,525
98,788
81,637.50
Project D
Year
1
2
3
4
5
Total present value
Initial investment
Net present value
Year
1
2
3
4
5
175,000
Total present value
Initial investment
Net present value
0.3855
67,462.50
512,032.50
500,000.00
12,032.50
300000
200000
100000
0
A
150000
100000
50000
0
A
* (HR - LR)
Project A
Year
CFs
1
136,000
2
136,000
3
136,000
4
618,800
Total present value
Initial investment
PVIF @ 26%
PV
0.7937
0.6299
0.4999
0.3968
107,943
85,666
67,986
245,540
507,135.84
-500,000.00
7,135.84
PVIF
@
27%
0.7874
0.62
0.4882
0.3844
PV
84,994
84,320
66,368
237,619.20
473,301.68
500,000.00
-26,698.32
Project B
Year
CFs
1
370,000
2
270,000
3
155,000
4
49,000
Total present value
Initial investment
PVIF @ 33%
PV
0.7519
0.5653
0.4251
0.3196
278,203
152,631
65,891
15,660
512,384.90
-500,000.00
PVIF
@
35%
0.7407
0.5487
0.4064
0.3011
PV
PVIF
@
30%
0.7692
0.5917
0.4552
0.3501
0.2693
0.2072
0.1594
0.1226
0.0943
0.0725
PV
12,384.90
274,059
148,149
62,992
14,754
499,953.90
500,000.00
-46.10
Project C
Year
CFs
PVIF @ 29%
PV
1
2
3
4
5
6
7
8
9
10
Total
value
Initial
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
323,000
0.7752
0.6009
0.4658
0.3611
0.2799
0.217
0.1682
0.1304
0.1011
0.0784
250,390
194,091
150,453
116,635
90,408
70,091
54,329
42,119
32,655
25,323
1,026,494
present
-1,000,000
248,452
191,119
147,030
113,082
86,984
66,926
51,486
39,600
30,459
23,418
998,555
-1,000,000
investment
Net
present
value
26,494
-1,445
Project D
Year
CFs
1
175,000
2
175,000
3
175,000
4
175,000
5
175,000
Total present value
Initial investment
PVIF @ 22%
PV
0.8197
0.6719
0.5507
0.4514
0.37
143,448
117,583
96,373
78,995
64,750
501,147.50
-500,000.00
1,147.50
PVIF
@
23%
0.813
0.661
0.5374
0.4369
0.3552
PV
142,275
115,675
94,045
76,458
62,160
490,612.50
500,000.00
-9,387.50
15.00%
10.00%
5.00%
0.00%
A
Discounted
Payback Period
15%
21%
Regular
Payback
Period
NPV
15%
IRR
21%
164345.04
3.15
year
3.54 year
3.76
year
1.48
year
1.87 year
2.11
year
3.10
year
5.53 year
4.49
year
2.86
year
4.004
year
4.82
year
86,635.00
70,720.60
12,032.50
Rank
Projects
Project A
PBP
IV
NPV
15%
21%
15%
21%
II
II
II
III
IRR
III
26.36%
22.12%
Project B
III
II
Project C
III
IV
IV
II
Project D
II
III
III
IV
IV
IV
Rank
Projects
Payback period
15%
21%
15%
21%
IRR
Project A
IV
II
II
II
III
III
Project B
III
II
Project C
III
IV
IV
II
Project D
II
III
III
IV
IV
IV
Rank the investment proposals considering the capital budget of $1.5 million.
The given rank has been given with the help of NPV summarized in above table. There may arise
some degree of problem while choosing between project A and project B. We may rank project
B in second place because it provide greater cash flow in earlier years so the Net Present Value is
greater even when the discount rate is higher. Even though project A has higher NPV than
project B at discount rate of 15% but the difference is much higher in favor of project B when
the discount rate has increased to 21%.
We have considered Net Present Value for ranking these projects because of following reasons:
All cash flows are discounted at the appropriate market-determined opportunity cost of
capital.
NPV of a project is exactly the same as the increase in shareholders wealth as can be
seen from below:
NPV@
NPV @ 15%
Rank
21%
Rank
A and C
1,500,000
785,417.44 1
380,130.30 2
B and C
1,500,000
621,072 2
809,409.70 1
C and D
1,500,000
707,707.4 3
321,442.2 3
A and D
1,000,000
250,980.04 4
82,753.10 5
B and D
1,000,000
242,464.70 5
$112,713.00 4
The company should choose the combination of Project A and Project C when discount rate is
15% whereas it will be beneficial for the company to choose the combination of Project B and
Project C when discount rate is 21%. The company should choose project C because it has much
higher NPV than other projects with very much acceptable IRR. Furthermore, Project C i.e.
Purchase of new press will enable the company to print high quality color calendars sold by
various wildlife and nature societies with high resolution color gaining good competitive
advantage for the company. The company should also choose Project A at 15% discount rate
along with C because it has the highest NPV after project C with highest IRR among the
alternative projects. The company should also choose Project B at 21% discount rate along with
C because it has the highest NPV after Project C with acceptable IRR among the alternative
projects.
decision to make, higher NPVs obtained at a discount rate of 15% makes it the more appropriate
discount rate to use.
Q.2
Payback Period:
It is the number of years required to recover the initial capital outlay on a project. It may be
computed as indicated below if cash are equal or even,
Payback period=
Though the payback period is a widely used method formally or informally, it has serious
limitations. Some of those are:
Fails to consider all the cash flows. Ignores cash flows occurring after the payback
period.
In case of discounted payback period as well, although it considers time value of money, it fails
to consider all the cash flows. Hence, payback period is good as a secondary measure only. The
firm cannot fully rely on this method only for choosing among the projects.
Net Present Value:
This method requires finding the present value of the expected net cash flows of an investment,
discounted at the cost of capital, and subtracting from it the initial cost outlay of the project. This
rule suggests that the project is worth accepting if NPV is positive else it should be rejected. It
requires that the firm knows its cost of capital or discounting factor precisely.
This method is good only if the firm knows the cost of capital or discounted factor fairly
correctly and which may not be the current cost prevailing in the market. Further on, the
investment that is made may not have the same level of risk throughout the entire time horizon.
Another drawback is that, it wholly excludes any real option that may exist within the
investment. Thus, NPV is a useful starting point to value investments, but certainly not a
definitive answer that an investor can rely on for all investment decisions.
Internal Rate of Return:
The IRR is defined as the interest rate that equates the present value of the expected future cash
flows, or receipts, to the initial cost outlay. The decision rule for acceptance and rejection is as
below:
If IRR > k, accept project
If IRR < k, reject project
K= cost of capital
The disadvantage of using this method as our selection criteria are:
1. To understand IRR is difficult
It is difficult to understand as there may be two experimental rates because of unequal
present value of cash inflow with present value of cash outflow.
2. Unrealistic Assumption
For calculating IRR we create one assumption. We think that if we invest our money on
this IRR, after receiving profit, we can easily reinvest our investments profit on same
IRR. This seems to be unrealistic assumption.
3. Not Helpful for comparing two mutually exclusive investment
IRR is not good for comparing two projects.
Virtually all general managers face capital-budgeting decisions in the course of their careers.
The most common of these is the simple yes versus no choice about a capital investment.
The following are some general suggestions to orient the decision maker in these situations.
1. Focus on cash flows, not profits. One wants to get as close as possible to the economic
reality of the project. Accounting profits contain many kinds of economic fiction. Flows
of cash, on the other hand, are economic facts.
2. Focus on incremental cash flows. The point of the whole analytical exercise is to judge
whether the firm will be better off or worse off if it undertakes the project. Thus one
wants to focus on the changes in cash flows affected by the project. The analysis may
require some careful thought: a project decision identified as a simple go/no-go question
may hide a subtle substitution or choice among alternatives. For instance, a proposal to
invest in an automated machine should trigger many questions: Will the machine expand
capacity (and thus permit us to exploit demand beyond our current limits)? Will the
machine reduce costs (at the current level of demand) and thus permit us to operate more
efficiently than before we had the machine? Will the machine create other benefits (e.g.,
higher quality, more operational flexibility)?
project proposals should be, How will things change (i.e., be better or worse) if we
undertake the project?
3. Account for time. Time is money. We prefer to receive cash sooner rather than later.
Use NPV as the technique to summarize the quantitative attractiveness of the project.
Quite simply, NPV can be interpreted as the amount by which the market value of the
firms equity will change as a result of undertaking the project.
4. Account for risk. Not all projects present the same level or risk. One wants to be
compensated with a higher return for taking more risk. The way to control for variations
in risk from project to project is to use a discount rate to value a flow of cash that is
consistent with the risk of that flow.
If the life of the project were unequal, then some adjustment would be necessary in the
method of analysis. They are basically two methods:
The replacement chain approach
Equivalent annual annuity approach
The replace method
A replacement chain is a method of comparing mutually exclusive projects that have
unequal lives. Each project is replicated such a way that they both terminate in a common
year If project with lives of 5 years and 20 years are being evaluated the project , the 5 year
project would be replicated 5 times and 10 year project replicated 2 years.
The Model: The EAA method is an alternative to the Replacement Chain method, for use in
evaluating projects with unequal lives. The EAA model derives a monetary value of the
project that represents the same financial value of the NPV, except that the monetary value
of the EAA is for payments or benefits that are equally spread over the life of the project
(an annuity). The annual annuity can be compared between projects, and the project with
the highest annuity should be chosen over lower annuity.
Find each project's EAA, the expected payment over the project's life, where the future
value of the project would equal zero.
Compare the EAA of each project and select the project with the highest EAA
Projects
At 15%
EAA
Projects
164345.04/PVIFA,4years
57563.94
54581.33
123749.10
25844.22
B
C
D
155,829.70/ PVIFA,10years
621,072.00
86,635.00/ PVIFA,5years
At 21%
70720.60/PVIFA,4years
100534/PVIFA,4years
308410/PVIFA,10years
12032.50/PVIFA,5years
The higher EAA is always associated with the higher NPV since the project C has higher
EAA compared to project A, B and D, the company should accept the project C.
Q4.
Discount Rate (K)
0
10
20
30
40
NPVA
526800
260845.2
84917.64
-36368.5
-36368.5
NPVB
344000
209413.5
109140.2
32073.9
-28718.3
EAA
27838.4
39574.1
76,320.19
4112.27
Graph showing the Cross Over rate for Project A and Project B
600000
500000
400000
300000
Discount rate
200000
NPVa
NPVb
100000
0
1
-100000
-200000
The above figure shows that the NPV profiles of both Project A and Project B decline as the
discount rate increases. It can be noted that, Project A has the higher NPV at low discount rate.
Project B has the higher NPV if the discount rate is greater than the cross over rate. The project
As NPV is more sensitive to changes in the discount rate as compared to project Bs NPV. In
other words, Project As net present value has the steeper slope. It indicates that a given change
in discount rate has larger effect on the net present values.
Project A
Project B
Difference PVIF@16% PV
PVIF@17% PV
(500000)
(500000)
136000
370000
(234000)
0.862
(201708)
0.855
(200070)
136000
270000
(134000)
0.743
(99562)
0.731
(97954)
136000
155000
(19000)
0.641
(12179)
0.624
(11856)
618800
49000
569800
0.552
314529.6
0.534
304273.2
Total
1080.6
(5606.8)
Therefore,
Crossover Rate=
=
Crossover Rate= 16.16%
This means that, we are indifferent between Project A and Project B when the cost if 16.35%.
Hence, when the cost in less than crossover rate, we will select project A and if the cost is more
than crossover rate, we will select project B.
In our case, Project B seems to be more superior as, it is good in all the aspect when compared to
project A. the payback period and discounted payback period, both supports project B. IRR for
Project B is also more when compare to project A. At higher cost of capital, Project B will
provide with more return than project A. Therefore, in all, project B seems to be superior to
Project A.
Q.4
Payback period
Payback period= year before recovered + remaining amount to recover
Recovered year cash flow
a) Ordinary payback period
year
Cash Flows
Original
Investment
Year 1
Year 2
Year 3
Year 4
Year 5
-500,000
195,000
195,000
195,000
195,000
195,000
cumulative Cumulative
cash flow Cash
Flows
-500,000
195,000
390,000
585,000
780,000
975,000
-305,000
-110,000
85,000
280,000
475,000
PVIF@15%
PV
Cumulative CFs
0
1
2
3
4
5
1
0.8696
0.7561
0.6575
0.5718
0.4972
-500,000
169,572
147,440
128,213
111,501
96,954
-500,000
-330,428
-182,989
-54,776
56,725
153,679
-500,000
195,000
195,000
195,000
195,000
195,000
Year Cash
Flows
PVIF@21% PV
1
2
3
4
5
500,000
195,000
195,000
195,000
195,000
195,000
0.826
0.683
0.565
0.467
0.386
Cumulative
CFs
500,000
161,070
133,185
110,175
91,065
75,270
-500,000
-338,930
-205,745
-95,570
-4,505
70,765
Year
Cash Flows
PVIF@15%
PV
1
2
3
4
5
Total present value
195,000
195,000
195,000
195,000
195,000
0.8696
0.7561
0.6575
0.5718
0.4972
169,572
147,440
128,213
111,501
96,954
653,679.00
Initial investment
Net present value
Year
Cash
Flows
1
195,000
2
195,000
3
195,000
4
195,000
5
195,000
Total present value
Initial investment
Net present value
-500,000.00
1,153,679.00
PVIF@21%
PV
0.8264
0.683
0.5645
0.4665
0.3855
161,148
133,185
110,078
90,968
75,173
570,550.50
-500,000.00
70,550.50
Year
CFs
1
195,000
2
195,000
3
195,000
4
195,000
5
195,000
Total present value
Initial investment
Net present value
PVIF @ 27%
PV
PVIF @ 28% PV
0.7874
0.62
0.4882
0.3844
0.3027
153,543
120,900
95,199
74,958
59,027
503,626.50
-500,000.00
3,626.50
0.7813
0.6104
0.4768
0.3725
0.291
152,354
119,028
92,976
72,638
56,745
493,740.00
-500,000.00
-6,260.00
Base
Ordinary
2.56 year
payback
3.49 year
period
Discounted
4.049 year
period
NPV
IRR
86,635.00
1,153,679.00
12,032.50
70,550.50
22.12%
27.37%
Discount
rate (a)
Combinations
(b)
Initial
Investment
(c)
NPV (d)
At 15%
A and C
1.5 million
(164,345.04+
=785417.04
At 15%
A and D
1 million
(164345.04+
318024.04
153679)
At 15%
B and C
1.5 million
(155829.7+
=776901.7
621072
At 15%
B and D
1 million
(155829.7+153679) = 309508.7
621,072)
PV (c+d)=e
Profitabilityindex
(e/c)
2285417.04
1.52
1318024.04
1.32
2276901.7
1.517
1309508.7
1.31
A and C
A and D
B and C
B and D
Among the different viable combination of projects, we suggest the company to choose the
project A and C as the profitability index of these projects is greater than the profitability
index of other combination of projects. From the table below we see that the company
should choose project A and C.
15%
A and C
1st
A and D
3rd
B and C
2nd
B and D
4th
Calculation of EAA
EAA = NPV / PVIFA (k%, n years)
At 15%
Project A
57645
Project B
54654
Project C
123749
Project D
45844
The higher EAA is always associated with the higher NPV since the project C has higher
EAA compared to project A, B and D, the company should accept the project C.
This situation does not have any effect on the mutually exclusive project
Q.5
The IRR of project A is approximately 27%. Since project As IRR is equal to reinvestment rate,
reinvestment rate would be 27% as well. Similarly, the IRR of project B is 35%.
It would be unreasonable for Mr. Hill to claim that project B will generate a return of
approximately 35 percent over its four-year life because the return of 35% is far higher compared
to the actual reinvestment rate in the market.
Reinvestment at the cost of capital is generally a better assumption because it is closer to reality.
Even if the MIRR is calculated, an expected return of 35% would be still high. It can be
demonstrated through the following calculation for Project B.
Year
Cash Inflows
FVIF @ 27%
$370,000.00
2.0483
$757,871.00
$270,000.00
1.6129
$435,483.00
$155,000.00
1.27
$196,850.00
$49,000.00
$49,000.00
FV of Inflows
$1,439,204.00
MIRR is calculated to determine the rate at which the present value of a projects outflow equals
the terminal value of the projects inflows. Trying at 35% and 25%, we get
PVIF @ 35% PV
Present
Value
of $1,439,204 0.3011
PVIF @ 25% PV
$433,344.32
0.4096
$589,497.96
$500,000
$500,000
Value
of $500,000
Outflow
NPV
$(66,655.68)
$89,497.96
An MIRR of 30.73% is lower by around 5% compared to the 35% IRR of project B. Although
NPV is the best method to use, MIRR is also an acceptable one. Since MIRR is superior to IRR,
and the MIRR obtained for project B is 30.73%, this is the most that Mr. Hill can claim that the
project will generate over the next five years. Anything above the MIRR rate would be uncertain
and risky.
Q6.
Egret Printing and Publishing Company, owned by the Belford brothers who possess extreme
conservative nature which was the outcome of the fact that their father had to struggle under a
crushing burden of debt during the Great Depression of 1930. It was mainly due to this that the
Belford brothers vowed never to get deeply into debt. However, Patrick Hill who was
responsible for managing the internal as well as the external financial operations of the company
has been trying to change the firms policy of not using any debt. He puts forward a proposal to
the Belford brothers in which he states that he would complete the current task of carrying out a
detailed analysis of four major capital investments using the existing capital structure but
lowering the cost of capital, by including long term debt in the capital structure. He even
discusses the issue with the companys bank which then provides him with certain information as
to how much could the company borrow, at what rate of interest which in turn would help Egret
to lower the weighted average cost of capital.
Patrick Hill is somehow confident of the fact that he will be able to persuade the Belford brothers
to make use of some amount of debt in their financial operations which would help the firm to
lower the cost of capital. The decision of whether to accept or reject the project totally depends
upon the comparison between the cost of capital and the return of the project .He considers the
use of debt financing to be extremely beneficial for the projects and he is sure that it will help the
company to be able to generate more and better projects in the coming years. However, he also
seems to be a bit confused about the fact that whether he will be able to persuade the Belford
brothers to employ debt financing. Hence, in order to be able to convince them completely
Patrick Hill needs to have strong and genuine support to his idea about debt financing. He needs
to support his idea by providing them with the advantages of debt financing. Hill has estimated
that the total amount of fund needed for the new project has to come from the Belford brothers
and also that if they do not make use of debt financing, the Belford brothers would have to
liquidate their personal security holdings. As the use of equity results in higher cost of capital
Mr. Hill will advise only those projects which have higher rate of return than cost of capital, and
thus are more risky.
Earlier when the company did not make use of debt, it could only invest in Projects A & C, but if
the company takes debt, it would increase the funds that would be available with the company
and which would further allow the company to invest in those projects that were not feasible
earlier. It is also stated that if the company has to make use of additional funds beyond $1.5
million, the Belford Brothers would have to liquidate their personal security and the company
would have to pay 21% as the cost of capital for this. But by making use of debt financing the
cost of capital would only be 12% and this would help in lowering the WACC which in turn
would improve the companys current NPV.
Hence, this proves that the use of debt financing is beneficial to the company which would help
in lowering the cost of capital and improve the cash flows in the business. Use of debt would
increase the level of investments by $500,000 and this would further make it possible for the
company to invest in project D. Now the company would have a total of 2 million of investable
fund which would allow the company to invest either in Project A, C and D or Project B, C and
D.
Q.7
If the Belfords agree to Hills proposal to use a modest amount of debt to finance the
projects this year, what would be its implication on the present capital structure and the cost of
capital? In term of future returns to the Belford families, what would be the impact be from using
this debt financing or what would be the extra value addition in present values of the selected
projects
Hill has been trying to change the philosophy of internal financing exercised by Belford brothers
to avoid the circumstance as their father faced. Hill considered all equity capital structure to be
overly conservative. If Belfords agree to Hills proposal to use debt financing, they will use
$500000 debt at 12% interest rate. So, the company has now, $ 2 million to invest in the projects
and can choose three projects.
Type of capital
Amount ($)
Weight
Percent
500,000
0.25
6.48 %
1.62
Preferred stock
Common equity
1,500,000
0.75
15%
11.25
Calculation of kdt:
Interest rate of debt (kd)
= 12%
12.87%
From the investment of 2,000,000 we can select three projects, we can choose A, C and D or B,
C and D as Project A and Project B are mutually exclusive.
Now,
With debt and equity financing at 12.87% cost of capital
Net present value of project A, C & D = NPV of Projects (A + C +D)
= $(203073.08+ 761820.79+ 117472.868)
=$ 1,082,366.738
Net present value of project B, C & D = NPV of Projects (B + C +D)
= $(177733.415+ 761820.79+ 117472.868)
=$ 1,057,027.073
Project A
Project A
Year Cash Flow PVIF @ 12.87%
1
136,000.00
0.886
2
136,000.00
0.785
3
136,000.00
0.6954
4
618,800.00
0.6161
Total present value
Initial investment
Net present value
PV @ 12.87%
120,496.00
106,760.00
94,574.40
381,242.68
703,073.08
-500,000.00
203,073.08
Project B
Year
Cash Flow
PVIF @ 12.87%
PV @ 12.87%
370,000.00
0.886
327,820.00
0.785
0.6954
0.6161
211,950.00
107,787.00
30,188.90
677,745.90
-500,000.00
177,745.90
2
3
4
270,000.00
155,000.00
49,000.00
Total present value
Initial investment
Net present value
Project C
Year
1
2
3
4
5
6
7
8
9
10
PV @ 12.87%
286,178.00
253,555.00
224,614.20
199,000.30
176,325.70
156,202.80
138,405.50
122,610.80
108,624.90
96,254.00
1,761,771.20
-1,000,000.00
761,771.20
Project D
Year
1
2
3
4
5
PV @ 12.87%
155,050.00
137,375.00
121,695.00
107,817.50
95,532.50
617,470.00
-500,000.00
117,470.00
Discount
rate
Combination
of Projects
Initial
Investment
NPV
PV of Inflow
Profitability
Index(PI)
12.87%
A, C & D
2 million
1,082,314.28
3,082,314.28
1.54
12.87%
B, C & D
2 million
1,056,987.10
3,056,987.10
1.53
From this table we can select projects A, C and D when the company takes the debt financing
with 12.87% cost of capital.
When 15% cost of capital was taken as discounting factor, the combined NPV of project A& C
reveals higher value. So, this was selected as the best combination. Also, there was internal
financing through retained earnings and excluded external financing through debt.
With all Equity financing at 15% cost of Capital:
Net present value of project A & C = NPV of Projects (A + C)
= $(164345.04+621,072.00)
=$ 785,417.04
The impact of using this debt financing is shown by the extra value addition in present values of
selected project:
Particulars
Amount
Net present value of selected projects after inclusion of debt in capital 1,082,314.74
structure (A)
Less: Net present value of selected projects before inclusion of debt in capital 785,417.04
structure. (B)
Extra value additional due to use of debt financing (A-B)
296,897.70
This shows that when debt financing is used the company can yield more NPV as debt financing
helps to leverage the capital structure. Debt financing is relatively cheaper financing method as
the company can utilize capital with lower rate. Therefore, instead of using the combination of
projects A & C, the combination of A, C & D should be selected taking into consideration the
profitability index which is calculated on the basis of NPV and Total PV of inflows.
Q.8
EBIT
$3,393,333.33
$60,000.00
EBT
$3,333,333.33
$1,533,333.33
EAT
$1,800,000.00
Less: Dividends
$300,000.00
Retained Earnings
$1,500,000.00
The use of debt amounting to $500,000 does not represent a significant risk to the company. The
times interest earned ratio calculated above demonstrates that the company has more than
sufficient earnings to meet the cost of debt. The companys EBIT is 56.5555 times the interest
expense to be paid for the debt capital. This is a very healthy times interest earned ratio which
represents a low amount of debt capital used by the company and small portion of EBIT to be
used for payment of cost of debt i.e. interest.
The use of debt would be risky if the times interest earned ratio had been dangerously low;
which would be a ratio of one or close to one.
Question no 9.
In this case Projects A and B are mutually exclusive projects which implies that only one project
can be chosen at a particular point of time. Hence only one project can be accepted at a time.
Project C is dependent upon projects A and B. Project C is a contingent project whose
acceptance or rejection is dependent on the decision to accept or reject Project A or B.
Another important implication in the earlier case is that a project combination of C and D could
never be used. Although a project combination of C and D requires $1,500,000, however, for C
to be implemented, further $500,000 needs to be invested in either Project A or B. This would
take the total investment to $2 million which the firm does not have when it is not using the debt
capital. . This would mean that to only the project combinations of A and C or B and C or A and
D or B and D are possible considering the budget available.
The way Project C has been handled earlier in the case is valid. Project is about purchase of new
printing equipment and press. Obviously, the purchase of new equipments would require larger
space requirements. Project A and B both deal with the new expansion would also include a new
bindery room and extra space for the Special Services Department that specializes in low volume
custom book printing and binding. Hence, the mutually exclusive projects A and B can provide a
Answer of 10.
Quantitative factors are those factors which can be measured in terms of numeric values. Such
factors are easier to evaluate because it gives monetary value. Here, payback period, Net present
value and IRR are some of the quantitative factors which are important for manager for making
investment proposal. But major drawback of these factors is factor alone cannot guarantee the
better decision it is quite confusing. It is confusing in the sense that all these three factors may
give different results, NPV may state project A is better whereas IRR may declare B is better and
Payback may say C is better. So, good manager must think of future and have to forecast
whether these projects will result in better return in long run or not. Therefore, we can say that
quantitative factors alone cannot provide better decision. So, quantitative measures can alone
cant give accurate answer. Therefore, qualitative factors should also consider in capital budget
evaluation. Qualitative factors are such which cannot be scored in numeric values but affects
more in organizations operation. These factors are very difficult to measure and we can show
exact impact of these factors in organization. Factors like: competition, suppliers relations,
customers power, governmental rules and regulations etc. Changing tax policies always affect in
organization overall business whereas political instability may result in huge business loss.
Here, combination of both quantitative and qualitative technique helps manager for good
decision. It is because quantitative factors review the past whereas qualitative factors forecast the
future.
can have a major impact on the business. The various important qualitative factors that must be
answered before making the decision for the project are as follows:
1. Is the organization capable of carrying out the project in terms of human resource,
availability of raw materials and suppliers?
2. What relationship exists between the project and the firm?
3. Is the market suitable to carry out the project?
4. What and who can be the competitors for the project which might make labor and capital
scarce?
5. What are the Macro environmental elements and the project?
6. Does this investment effects the quality of products and services offered?
There are three basic assumptions related to the NPV analysis, but however they do not consider
the three qualitative factors that have been mentioned in the paragraph above. This analysis also
states that the decisions that are made by the company do not affect the competitors and the ways
the competitors react in turn do not affect the profitability of the firm. However it is also
assumed that the various macro environmental forces will continue to be the same even in the
future and it will not affect the decision criteria for the project. This is not a right method but a
very essential component of most of the financial models such as the NPV analysis. The NPV is
calculated as a combination of quantitative as well as qualitative factors and this serves as the
basis of the decision support information. The information from this is then made use of by the
analysts in order to make certain recommendations and also to take a major decision as to
whether accept or reject a project.
There are also other factors such as the various dynamic and competitive environment factors
that need to be considered, since most of the projects are strategic and not just financial in their
nature. But in certain situations only the quantitative factors such as NPV is considered, but this
might lead them to miss on some of the best investing opportunities. Looking at NPV alone will
lead the managers to take bad decisions. It should be seen to it that the project that the company
is investing in should be beneficial and innovative even in the future. That project should lead
the company to growth and help the company attain a better strategic position