Capital Budgeting Tutorial with solutions

Basics of Capital Budgeting



1 You are a financial analyst for Damon Electronics Company. The director of capital budgeting has

asked you to analyze two proposed capital investments, Projects X and Y. Each project has a cost

of $10,000, and the required rate of return for each project is 12 percent. The projects’ expected

net cash flows are as follows:

Expected Net Cash Flows
Year Project X Project Y
0 $(10,000) $(10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
a. Calculate each project’s traditional payback period (PB), net present value (NPV), internal rate

of return (IRR), modified internal rate of return (MIRR), and discounted payback period

(DPB).

b.Which project or projects should be accepted if they are independent?

c. Which project should be accepted if they are mutually exclusive?

d.How might a change in the required rate of return produce a conflict between the NPV and IRR

rankings of these two projects? Would this conflict exist if r were 5 percent? (Hint: Plot the

NPV profiles.)

e. Why does the conflict exist?

, a. Payback:


To determine the payback, construct the cumulative cash flows for each project:
Project X Project Y

Year Cash Flows Cumulative CF Cash Flows Cumulative CF

0 ($10,000) ($10,000) ($10,000) ($10,000)

1 6,500 (3,500) 3,500 (6,500)

2 3,000 (500) 3,500 (3,000)

3 3,000 2,500 3,500 500

4 1,000 3,500 3,500 4,000

$500
Payback X  2   2.17 years
$3,000
$3,000
Payback Y  2   2.86 years
$3,500

Net present value (NPV):


$6,500 $3,000 $3,000 $1,000
NPVX  $10,000  1
 2
 3

(1.12) (1.12) (1.12) (1.12)4
 $10,000  $5,803.57 $2,391.58 $2,135.34 $635.52
 $966.02


$3,500 $3,500 $3,500 $3,500
NPVY  $10,000  1
 2
 3

(1.12) (1.12) (1.12) (1.12)4
 $10,000  $3,125.00 $2,790.18 $2,491.23 $2,224.31
 $630.72