Chapter 11
The Basics of Capital Budgeting
Learning Objectives
After reading this chapter, students should be able to:
◆ Discuss capital budgeting.
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Lecture Suggestions
Chapter 11: The Basics of Capital Budgeting
Lecture Suggestions
This is a relatively straight-forward chapter, and, for the most part, it is a direct application of the time
value concepts first discussed in Chapter 5. We point out that capital budgeting is to a company what
buying stocks or bonds is to an individual—an investment decision. The company wants to know if the
DAYS ON CHAPTER: 4 OF 56 DAYS (50-minute periods)
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Answers to End-of-Chapter Questions
11-1 Project classification schemes can be used to indicate how much analysis is required to evaluate
11-2 The regular payback method has three main flaws: (1) Dollars received in different years are all
11-4 Mutually exclusive projects are a set of projects in which only one of the projects can be
accepted. For example, the installation of a conveyor-belt system in a warehouse and the
11-5 The first question is related to Question 11-3 and the same rationale applies. A high cost of
11-6 The statement is true. The NPV and IRR methods result in conflicts only if mutually exclusive
projects are being considered because the NPV is positive if and only if the IRR is greater than
11-7 Payback provides information on how long funds will be tied up in a project. The shorter the
11-8 Project X should be chosen over Project Y. Because the two projects are mutually exclusive, only
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Chapter 11: The Basics of Capital Budgeting
11-9 The NPV method assumes reinvestment at the cost of capital, while the IRR method assumes
reinvestment at the IRR. MIRR is a modified version of IRR that assumes reinvestment at the
at the cost of capital.
11–10 a. In general, the answer is no. The objective of management should be to maximize value,
and as we point out in subsequent chapters, stock values are determined by both earnings
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Solutions to End-of-Chapter Problems
FV inflows:
PV FV
0 1 2 3 4 5 6 7 8
| | | | | | | | |
12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000
11-5 Project K’s discounted payback period is calculated as follows:
Annual Discounted @12%
Period Cash Flows Cash Flows Cumulative
0 ($52,125) ($52,125.00) ($52,125.00)
1 12,000 10,714.29 (41,410.71)
12%
1.12
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Chapter 11: The Basics of Capital Budgeting
11-6 a. Project A: Using a financial calculator, enter the following:
CF0 = –25, CF1 = 5, CF2 = 10, CF3 = 17, I/YR = 5; NPV = $3.52.
b. Using the data for Project A, enter the cash flows into a financial calculator and solve for
c. At a WACC = 5%, NPVA > NPVB so choose Project A.
11-7 a. Project A:
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Payback calculation:
0 1 2 3 4 5
| | | | | |
-6,000 2,000 2,000 2,000 2,000 2,000
14%
Project B:
MIRR calculation:
0 1 2 3 4 5
Payback calculation:
14%
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Chapter 11: The Basics of Capital Budgeting
Discounted payback calculation:
0 1 2 3 4 5
| | | | | |
-18,000 5,600 5,600 5,600 5,600 5,600
Summary of capital budgeting rules results:
Project A Project B
NPV $866.16 $1,225.25
11-8 a. No mitigation analysis (in millions of dollars):
0 1 2 3 4 5
| | | | | |
–60 20 20 20 20 20
b. The environmental effects if not mitigated could result in additional loss of cash flows and/or
12%
14%
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c. Even when mitigation is considered the project has a positive NPV, so it should be
11-9 a. No mitigation analysis (in millions of dollars):
0 1 2 3 4 5
| | | | | |
–240 80 80 80 80 80
b. If the utility mitigates for the environmental effects, the project is not acceptable. However,
11-10 Project A: Using a financial calculator, enter the following data: CF0 = -400; CF1-3 = 55; CF4-5 =
11-11 Project S: Using a financial calculator, enter the following data: CF0 = -15000; CF1-5 = 4500;
17%
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Chapter 11: The Basics of Capital Budgeting
11–12 Input the appropriate cash flows into the cash flow register, and then calculate NPV at 10% and
the IRR of each of the projects:
11–13 Because both projects are the same size you can just calculate each project’s MIRR and choose
the project with the higher MIRR.
11–14 a. HCC: Using a financial calculator, enter the following data: CF0 = -600000; CF1-5 = –50000;
Chapter 11: The Basics of Capital Budgeting
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c. HCC: I/YR = 15; solve for NPV = -$767,607.75.
11–15 a. Using a financial calculator, calculate NPVs for each plan (as shown in the table below) and
graph each plan’s NPV profile.
Discount Rate NPV Plan A NPV Plan B
0% $2,400,000 $30,000,000
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Chapter 11: The Basics of Capital Budgeting
11-16 a. Using a financial calculator, we get:
b. Using a financial calculator, calculate each plan’s NPVs at different discount rates (as shown
in the table below) and graph the NPV profiles.
Discount Rate NPV Plan A NPV Plan B
0% $88,000,000 $42,400,000
80
100
NPV
(Millions of
Dollars)
Plan A
c. To calculate the crossover rate, create Project which represents the cash flow differences
d. The NPV method implicitly assumes that the opportunity exists to reinvest the cash flows
generated by a project at the WACC, while use of the IRR method implies the opportunity to
11–17 a. Using a financial calculator, enter each project’s cash flows into the cash flow registers and
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c. Here is the MIRR for Project A when WACC = 12%:
d. WACC = 12% criteria:
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Chapter 11: The Basics of Capital Budgeting
e.
f. To calculate the crossover rate, create Project which represents the cash flow differences
between the two projects. The IRR of Project is the crossover rate.
Year CFA CFB CF = CFA – CFB
0 –300 –405 105
g. Here is the MIRR for Project A when WACC = 18%:
1,000
900
800
700
600
NPV
($)
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Using a financial calculator enter the following inputs: N = 7; PV = -883.95; PMT = 0; and FV
= 2824.26. Then, solve for I/YR = MIRRA = 18.05%.
11–18 Facts: 5 years remaining on lease; rent = $2,000/month; 60 payments left, payment at end of
month.
a. 0 1 2 59 60
| | | • • • | |
-2,000 -2,000 -2,000 -2,000
b. At t = 9 the FV of the original lease’s cost = -$89,910.08(1.01)9 = -$98,333.33. Since lease
1%
1%
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Chapter 11: The Basics of Capital Budgeting
c. Period Old Lease New Lease Lease
0 0 0 0
11–19 a. The project’s expected cash flows are as follows (in millions of dollars):
Time Net Cash Flow
We can construct the following NPV profile:
NPV
(Millions of Dollars)
1.5
1.0
NPV
(Millions of Dollars)
1.5
1.0
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d. MIRR @ WACC = 10%:
11–20 Because the IRR is the discount rate at which the NPV of a project equals zero, the project’s
inflows can be evaluated at the IRR and the present value of these inflows must equal the
11–21 Step 1: Determine the PMT:
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Chapter 11: The Basics of Capital Budgeting
Step 2: We’ve been given the WACC, so once we have the project’s cash flows we can now
calculate the project’s MIRR.
Calculate the project’s MIRR:
11–22 The MIRR can be solved with a financial calculator by finding the terminal future value of the
Chapter 11: The Basics of Capital Budgeting
Comprehensive/Spreadsheet Problem
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Comprehensive/Spreadsheet Problem
Note to Instructors:
The solution to this problem is not provided to students at the back of their text. Instructors
can access the
Excel
file on the textbook’s website.
11–23 a. Project A:
Using a financial calculator, enter the following data:
Payback A (cash flows in millions):
Annual
Period Cash Flows Cumulative
0 ($30) ($30)
Discounted Payback A (cash flows in millions):
Annual Discounted @10% Cumulative
Period Cash Flows Cash Flows Cash Flows
0 ($30) ($30.00) ($30.00)
Project B: