Capital Budgeting

Solve the following problems. Create appropriate formulas using the supplied values in the corresponding cells so Excel can calculate the answer. Example problems can be found on the “Capital Budgeting Example” tab below.

1. Compute the NPV statistic for Project Y. Explain whether or not the firm should accept or reject the project with the cash flows shown in the chart below if the appropriate cost of capital is 10 percent.

Year Cash Flow

0 -$8,000

1 $3,350

2 $4,180

3 $1,520

4 $300

NPV= [NPV Calc. here]
[Brief Explanation]
2. Compute the payback period statistic for Project X and recommend whether the firm should accept or reject the project with the cash flows shown in the chart if the maximum allowable payback is four years.

Year Cash Flow

0 -$1,450

1 $250

2 $380

3 $620

4 $1,000

5 $100

Payback period = [Answer here]
3. Two projects being considered are mutually exclusive and have the following projected cash flows: (Compute both NPV and IRR). The cost of capital is 10%.

Year Cash Flow A Cash Flow B

0 -$50,000 -$50,000

1 $15,625 $0

2 $15,625 $0

3 $15,625 $0

4 $15,625 $0

5 $15,625 $99,500

NPV = [Answer here] [Answer here]
IRR = [Answer here] [Answer here]
4. Los Angeles Lumber Company is considering a project with a cost of $1,000 initially, and inflows of $300 at the end of years 1-5. LALC’s cost of capital is 12 percent. What is the project’s IRR and NPV? IRR NPV

5. A Project has a cost of $65,000 and it’s expected cash inflows are $12,000 per year for 9 years and the cost of capital is 10%. What is the project’s IRR and MIRR? IRR MIRR

6. Explain which capital budgeting method is better, NPV, IRR or MIRR. [Answer here]
Capital Budgeting Example

TVM: NPV and IRR

Practice Problem Worksheet using Excel Formulas

Net Present Value (NPV) Calculation

Solving for the Net Present Value (NPV):

Problem 1: Here is a simple net present value (NPV) calculation problem:

What is the NPV statistic for the following indicated Cash Flows assuming

the appropriate cost of capital is: 14%

Time: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash Flow: -100,000 25,000 35,000 45,000 35,000 25,000

Solution: Using the Excel, Formulas, Financial, NPV formula that calculates the present values of cash flows from year 1 and beyond, and first entering the cash flow at time point 0 (outside of the NPV formula function) because cash at time point 0 does not require a present value calculation because the present value of an amount at time point 0 (or now) equals its stated value:

NPV = Minus Cash Outflow at time point 0 + [NPV (Int rate or cost of capital, CF Yr 1, CF Yr 2, CF Yr 3 … )

Solution inputting the numbers into the Excel NPV formula in the exact order prescribed by the formula (click on Cell B29 and/or B31 to see the contents of the cell as inputted):

NPV = $12,941.93 This approach uses the problem’s numbers inputted into the formula.

NPV = $12,941.93 This approach uses the appropriate cells inputted into the formula.

Either approach is acceptable.

Is the above project desirable? Yes, since the project’s NPV is greater than $0; the project is earning $12,941.93 more than its cost of capital.

Problem 2

What is the NPV statistic for the following indicated Cash Flows assuming the appropriate cost of capital is 11%.

11%

Time: Year 0 Year 1 Year 2 Year 3 Year 4

Cash Flow: -12,000 2,000 3,000 4,000 5,000

NPV = ($1,544.91) This approach uses the problem’s numbers inputted into the formula.

NPV = ($1,544.91) This approach uses the appropriate cells inputted into the formula.

Either approach is acceptable.

Is the above project desirable? No, since the project’s NPV is less than $0; the project is earning $1,544.91 less than the cost of capital.

Internal Rate of Return (IRR) Calculation

Solving for Internal Rate of Return (IRR) Problem 1:

What is the Internal Rate of Return for the following indicated Cash Flows?

Time: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash Flow: -100,000 25,000 35,000 45,000 35,000 25,000

Solution: Using the Excel, Formulas, Financial, IRR formula that reads as follows:

IRR = (Range of initial cash outflow and subsequent cash inflow values by year beginning at CF0)

Solution inputting the numbers into the Excel IRR formula in the exact order prescribed by the formula (click on Cell B75 and to see the contents of the cell as inputted):

IRR = 19% You need to adjust the B71 cell to allow showing additional decimals (at least 4 decimal places) as reflected in cell B72.

IRR = 19.16%

If we are now advised the firm’s cost of capital is 14%, is the above project desirable? Yes, the project is desirable since the project’s IRR of 19.16% is greater than the project’s cost of capital of 14%. Notice you do not use the cost of capital to calculate IRR, however, you do compare the calculated IRR to the cost of capital that serves as the benchmark.

Problem 2

What is the Internal Rate of Return (IRR)for the following Cash Flows?

Time: Year 0 Year 1 Year 2 Year 3 Year 4

Cash Flow: -12,000 2,000 3,000 4,000 5,000

IRR = 6% You need to adjust the B87 cell to allow showing additional decimals (at least 4 decimal places) as reflected in cell B88.

IRR = 5.61%

If we are now advised that the firm’s cost of capital is 11%, is the above project desirable? No, the project is not desirable since the project’s IRR of 5.61% does not exceed the project’s cost of capital of 11%. Notice you do not use the cost of capital to calculate IRR, however, you do compare the calculated IRR to the cost of capital that serves as the benchmark.