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X-treme Vitamin Company is considering two investments, both of which cost $20,000. The firm's cost of capital is 15 percent. The cash flows are as follows:

Year

Project A

Project B

1

12,000

10,000

2

8,000

6,000

3

6,000

16,000

L-t

Required: Show all workings

What is the payback period for each project? Which project would you accept based on the payback period? . (2 marks)

What is the discounted payback for each project? Which project would you accept based on the discounted payback criterion? (3 marks)

Calculate the NPV of each project? Which project would you choose based on the NPV criterion? (5 marks)

Based on the IRR criteria which project would you choose if they were mutually exclusive

(5 marks)

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Reid Wolff
Reid WolffLv2
28 Sep 2019

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QUESTION 6 [Total 29 marks]

A listed company has a proposed investment project where the expected cash flows are given in the table below. Market research into a feasibility study for the project was conducted at a cost of $5,000. The risk-free rate of return is given as 2% per annum. The yearly return for the Australian share market is given as 12%. Suppose the company has a beta value of 0.8.

Year 0 Project cash flow $(20,000)

Year 1 Project cash flow $(10,000)

Year 2 Project cash flow $(20,000)

Year 3 Project cash flow $(10,000)

Year 4 Project cash flow $(40,000)

Year 5 Project cash flow $(30,000)

(a) Determine the project’s discount rate. (4 marks)

(b) Explain what is meant by sunk costs in capital budgeting. State the amount of any sunk costs for the project. (2 marks)

(c) What type of risk does the beta value measure? Explain what is meant by this particular type of risk. (2 marks)

(d) If the maximum acceptable payback period for the project is 3 years, would the project be accepted? What are the disadvantages of the payback period method in making investment decisions? (5 marks)

(e) Explain the difference between the discounted payback period method and the payback period method. Would the project be accepted if the discounted payback period is used instead of the payback period? (5 marks) 5

(f) Explain whether the project would be accepted using the net present value (NPV) acceptance criterion. Explain why the NPV method is considered to be the best method in capital budgeting. (5 marks)

(g) Explain whether the project would be accepted using the profitability index (PI) acceptance criterion. (3 marks)

(h) Explain whether the project would be accepted using the internal rate of return (IRR) acceptance criterion. Explain why the IRR method is widely used in capital budgeting. (3 marks)

Year/Project A/ProjectB

1$ (43,500.00)$ (43,500.00)

2 $ 21,400.00 $ 6,400.00

3 $ 18,500.00 $ 14,700.00

4 $ 13,800.00 $ 22,800.00

5 $ 7,600.00 $ 25,200.00

1. Using the above cash flows, calculate the following for each project. Assume a 11% required return a. NPV b. Payback Period c. Discounted Payback Period d. IRR e. MIRR (Combination Approach: Use discount rate given and reinvestment rate of 8%) 2. Assuming independent projects, provide an accept/reject decision for each capital budgeting tool a. Assume payback period criteria is 2.5 years b. Assume discounted payback period criteria is 3 years 3. Assuming mutually exclusive projects, which project should be selected? Why?

Quattro, Inc. has the following mutually exclusive projects available. The company has historically used a 2.5-year cutoff for projects. The required return is 14 percent.


Year: Cash flow (A) Cash flow (B)

0 -$54,000 -$23,000

1 12,700 11,600

2 23,200 11,200

3 27,600 12,500

4 46,500 6,000



a. What are the payback periods for project A and B? Based on payback rule, which project would the firm choose?

b. What are the NPVs for project A and B? Based on NPV rule, which project, if any, should the company accept?

c. What are the IRRs for project A and B? Based on IRR rule, which project, if any, should the company accept?

Based on the above answers, which project will you finally choose? Why?

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