# Capital Budgeting Practice Problems a. Consider the

Question

Part 1. Capital Budgeting Practice Problems

a. Consider the project with the following expected cash flows:

Year Cash flow

0 -$400,000

1 $100,000

2 $120,000

3 $850,000

•If the discount rate is 0%, what is the project’s net present value?

•If the discount rate is 2%, what is the project’s net present value?

•If the discount rate is 6%, what is the project’s net present value?

•If the discount rate is 11%, what is the project’s net present value?

•With a cost of capital of 5%, what is this project’s modified internal rate of return?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the “x” axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand ‘smooth’ curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

[ Look at the graph you draw and write a short paragraph stating what the graph ‘shows”]..

b. Consider a project with the expected cash flows:

Year Cash flow

0 -$815,000

1 $141,000

2 $320,000

3 $440,000

•What is this project’s internal rate of return?

•If the discount rate is 1%, what is this project’s net present value?

•If the discount rate is 4%, what is this project’s net present value?

•If the discount rate is 10%, what is this project’s net present value?

•If the discount rate is 18%, what is this project’s net present value?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the “x” axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand ‘smooth’ curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

[ Observe the graph and write a short paragraph stating what the graph ‘shows]

c. A project requiring a $4.2 million investment has a profitability index of 0.94. What is its net present value? (Remember: Profitability Index is defined as Present Value of the proceeds divided by the initial investment)

Part 2.

Read the article below. Then write a one-to-two page paper answering the following question:

Which method do you think is the better one for making capital budgeting decisions – IRR or NPV?

Defend your answer with references to the background materials.

Please read the following article which is available in Proquest:

Internal rate of return

Computerworld. Framingham, Feb 17, 2003, Gary H Anthes.

Abstract:

Internal rate of return (IRR) is the flip side of net present value (NPV) and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often a company’s cost of capital. IRR, on the other hand, computes a break-even rate of return. It shows the discount rate below which an investment results in a positive NPV and above which an investment results in a negative NPV. It is the breakeven discount rate, the rate at which the value of cash outflows equals the value of cash inflows.