9 Capital Budgeting Class Problem

Q1. A machine has a life of three years, with cash outflow at t=0 of 870.
98 and 3
cashflows in year 1-3 of $226.66. The discount rate is 18.69% per year. The
equivalent annual cost (EANPV) of this machine is = __________________ ???
CF0 = 870.98 CF1 = 226.66 CF2 = 226.66 CF3 = 226.66

NPV = 870.98 + 226.66/ 1.1869 + 226.66/1.1869^2 + 226.66/1.1869^3
NPV = =1358.40487
CF0 here is cash outflow just like other CF. All CF
here is cash outflow.
1358.404871
EANPV = 1−
1
(1.1869)
3 = 1358.404871
2.15046
0.1869
EANPV = 631.68
Q2. You are attempting to reconstruct a project analysis of a co-worker who was
fired for flunking FI 3300. You have found the following information:
The IRR is 14%.
The project life is 6 years.
The initial cost is $16,000.
In years 1, 2, 3 and 4 you will receive cash inflows of $3,000.
You know the cash flows in years 5 and 6 are equivalent, but the amount is not on
file.
The appropriate discount rate is 10%.
What is the NPV of the project?
a. $2,335.25
b. $5,750.35
c. ($1,250)
d. $2,000
e. None of the above
Let’s Assume Cash flow year 5 and year 6 is ‘X’.

For IRR NPV = 0
3,000 3,000 3,000 3,000 x x

NPV =
(1+0.14 )
1 + (1+0.14 ) +¿
2
(1+0.14 )
3 +¿
(1+0.14 )
4 +¿
(1+0.14 )
5
+¿
(1+0.14 ) –
6
16,000
x x
0 = -$7,258.86 + (1+0.14 ) +¿ 5
(1+0.14 )
6
x ( 1.14 )+ x 2.14 x 2.14 x
$7,258.86 = (1+ 0.14)
6 = (1.14) =
6
2.195
2.14 x
$7,258.86 = 2.195
7,258.86∗2.195
X= 2.14 = 7443.39
This time r = 10%

3,000 3,000 3,000 3,000 7443.39 7443.39
NPV =
(1+0.1)
1 + (1+0.1) +¿2
(1+0.1)
3 +¿
(1+0.1)
4 +¿
(1+0.1)
5
+¿
(1+0.1) –
6
16,000
= 2332.96
Q3. Kim Lee is analyzing two projects. The first requires a $1,200 initial
investment and returns $600 a year for four years. The second project requires a
$1,500 initial investment and returns $700 a year for four years. What is the
crossover point for these two projects?
a. 4.25%
b. 6.37%
c. 8.14%
d. 12.59%
e. The crossover point cannot be computed based on the information provided.
Project 1 Project 2 Difference
CF0 -1200 -1500 -300
CF1 600 700 100
CF2 600 700 100
CF3 600 700 100
CF4 600 700 100
For cross over to work difference needs to be 0 in NPV

To find the crossover point we need to find K where difference in cash flow will
have NPV = 0
Now we have to use financial calculator to calculate IRR. For IRR, NPV = 0.
So, difference will automatically be 0.
New Cash flow,
Difference
CF0 -300
CF1 100
CF2 100
CF3 100
CF4 100
CPT IRR = 12.59

Q4. Peter is considering a project with an initial cost of $42,000 and annual cash
inflows of $9,100 a year for six years. What discount rate, when applied to this
project, will produce a profitability index of 1.0?
a. 7.00% b. 7.65% c. 7.88% d. 8.05% e. None of the above
PI = 1, when PV(cash inflow) = PV (Cash Outflow)

So, PV(cash inflow) - PV (Cash Outflow) = 0 = NPV
NPV is 0 for IRR
CF0 -42,000
CF1 9,100
CF2 9,100
CF3 9,100
CF4 9,100
CF5 9,100
CF6 9,100
Use the cash flow above and compute IRR.

CPT IRR = 8.05
Q5. As the required rate of return changes from 11% to 16.84% which of the
following statements is true when cash flow is normal? (Multiple options can be
answer)
a) Discounted payback period decreases
b) Profitability index decreases
c) Net present value increases
d) IRR Decreases
e) Wealth of investor decreases
Correct Answer is option B and option E
For a typical project CF0 will be cash outflow or investment.

So, the rest of the cash flow will be discounted.
In general, the rest of the cash flow are cash inflow.
So, higher interest rates will decrease the value of PV of cash Inflow
Consequently, PI decreases.
Option B is correct.
Also, if PV of cash inflow decreases then NPV also decreases. So, E is correct
Q6. PowerRus Company is considering a project that calls for an initial cash outlay
of $50,000. The expected net cash inflows from the project are $6,000 every two
years in perpetuity. What is the IRR of the project?
A) 5.83%
B) 6.00%
C) 8.33%
D) 12%
E) None of the above
For Perpetuity with interval,

PV = PMT / {(1+k)n -1} , payment is made every “nth” year
0 = 6,000 / {(1+k)2 -1} -50,000

50,000 = 6,000 / {(1+k)2 -1}
(1+k)2 -1 = 6000/50,000
(1+k)2 -1 = 0.12
(1+k)2 = 1.12
1+ k = 1.0583
K = 0.0583 = 5.83%
Q7. TrueNorth Company is considering a project that calls for

an initial cash outlay of $46700. The expected net cash
inflows from the project are $6812 every 5 years in
perpetuity. What is the effective annual IRR of the project?
Select one:
a. 2.92% b. 2.76% c. 14.59% d. 97.55% e. 4917.86%
For Perpetuity with interval,

PV = PMT / {(1+k)n -1} , payment is made every “nth” year
0 = 6,812 / {(1+k)5 -1} -46,700
46,700 = 6,812 / {(1+k)5 -1}
(1+k)5 -1 = 6812/46,700
(1+k)5 -1 = 0.14586
(1+k)5 = 1.14586
1+ k = 1.145861/5
1+ k = 1.0276
K = 0.0276 = 2.76%
Q8. PowerRus Company is considering a project that calls for an initial cash outlay
of $50,000. The expected net cash inflows from the project are $5,280 per year in
perpetuity. What is the IRR of the project?
PV = PMT/K
NPV = PMT/k – 50,000
0 = PMT/k – 50,000
50,000 = PMT/K
50,000 = 5280/K
K = 5280/50,000
K = 10.56%

9 Capital Budgeting Class Problem

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Q1. A machine has a life of three years, with cash outflow at t=0 of 870.

CF0 = 870.98 CF1 = 226.66 CF2 = 226.66 CF3 = 226.66

Let’s Assume Cash flow year 5 and year 6 is ‘X’.

3,000 3,000 3,000 3,000 x x

This time r = 10%

For cross over to work difference needs to be 0 in NPV

CPT IRR = 12.59

a. 7.00% b. 7.65% c. 7.88% d. 8.05% e. None of the above

PI = 1, when PV(cash inflow) = PV (Cash Outflow)

Use the cash flow above and compute IRR.

Correct Answer is option B and option E

For a typical project CF0 will be cash outflow or investment.

For Perpetuity with interval,

0 = 6,000 / {(1+k)2 -1} -50,000

Q7. TrueNorth Company is considering a project that calls for

a. 2.92% b. 2.76% c. 14.59% d. 97.55% e. 4917.86%

For Perpetuity with interval,

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