Corporate Financial Management
Workshop Answers WEEK 10
(Capital Budgeting and Basic Cash Management)
1.
The Noslan Plumbing Company is considering expanding its operations by
purchasing a truck specially outfitted for work involving the unblocking of drains.
The truck can be purchased for $140,000, fully equipped, and would have a useful
working life of 10 years: there would be no installation costs. This purchase price
would be depreciated fully over the truck’s working life using prime cost (straightline) depreciation, and the truck would have an expected salvage value of $20,000
after 10 years. The company pays a tax rate of 30%. If the new truck were put
into operation, an increase in net working capital of $8,000 would be required.
Purchase and operation of the truck would increase the company’s annual profit
before depreciation and taxes by $28,000 over the useful life of the truck (i.e.
ignoring any interest expense).
(a) For the project involving purchase and operation of the truck, calculate the
initial investment, annual operating cash inflow and terminal net cash flow for
capital budgeting purposes (i.e. the relevant incremental after-tax cash flows).
(b) Supposing the appropriate cost of capital for the project involving purchase
and operation of the truck is 9% per annum, calculate the net present value of
the project. State whether the project is acceptable or not by the net present
value criterion.
(c) Assuming the project of purchasing and operating the truck is ‘ongoing’ in the
sense that the truck would be replaced by a similar truck at the end of its
working life, determine the annual net present value (ANPV) of the project,
again assuming a 9% per annum cost of capital.
Answer:
a)
Initial investment  140,000  8,000
 $148,000 (An outflow)
140,000
 14,000
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Annual net profits before taxes  28,000  14,000  14,000
Annual net profits after taxes  0.7(14,000)  9,800
Annual operating cash inflow  9,800  14,000  23,800
Annual depreciation

Terminal net cash inflow
 20,000  0.3 (20,000)  8,000  22,000
b)
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23,800[1  (1.09) 10 ] 22,000
NPV 

 148,000  $14,033.29
0.09
(1.09)10
Since the NPV is positive, the project is acceptable.
c)
ANPV 
2.
NPV  r
14,033.29 (0.09)

 $2,186.67
1  (1  r ) n
1  (1.09) 10
GJF, Problem 10-6 (p. 456)
“Murdoch Paints is in the process of evaluating two mutually exclusive additions
to their processing capacity. The firm’s financial analysts have developed
pessimistic, most likely and optimistic estimates of the annual net cash inflows
associated with each project. These estimates are given in the following table.
Initial Investment
Outcome
Pessimistic
Most likely
Optimistic
(a)
(b)
(c)
(d)
Project A
$8000
Project B
$8000
Annual net cash inflows (CF)
$200
$900
1000
1000
1800
1100
Determine the range of annual net cash inflows for each of the two projects.
Assume that the firm’s cost of capital is 10% and that both projects have
20-year lives. Construct a table similar to that above for the NPVs for each
project. Include the range of the NPVs for each project.
Do parts (a) and (b) provide consistent views of the two projects? Explain.
Which project would you recommend? Why?
Answer:
(a)
Range B = $1,100 – $900 = $200
Range A = $1,800 – $200 = $1,600
(b)
Net Present Value
Outcome
Pessimistic
Most likely
Optimistic
Range
Project A
-$6,297.29
513.56
7,324.41
$13,621.70
Project B
-$337.79
513.56
1,364.92
$1,702.71
For example for the pessimistic case for Project A:
2
200 [1  (1.1) 20 ]
NPV 
 8,000  $6,297.29
0.1
(c)
Since the initial investment of projects A and B are equal, the range of cash
flows and the range of NPVs are consistent.
(d)
Project selection would depend upon the risk disposition of the management.
(A is more risky than B but also has the possibility of a greater return.)
3.
Your friend is seeking your advice because he believes you have studied finance so
must be good at making financial decisions. He is considering investing in a small
business that has the following features: the business costs $20,000. It will generate
a net cash inflow of $1500 in one year’s time since inception of the project but the
cash inflow will grow thereafter at 1.5% p.a. for an indefinite period of time. Your
friend requires a return of 8% p.a. from the investment. Using the NPV method,
recommend whether your frienda)
should invest in the business because its NPV is +$3,076.92.
b)
Should invest in the business because its NPV is +$23,076.92.
c)
Should invest in the business because its NPV is +$18,750.
d)
should invest in the business because its NPV is +$100,000
Answer: a)
This is a case of growing perpetuity (recall the constant dividend growth model that we
consider in stock valuation). We can find the present value as under:
Present Value of the business = 
pmt
$1500

 $23,076.92
ke  g 0.08  0.015
Hence, NPV = $23,076.92 -$20,000 = $3076.92. The positive NPV implies that the
project can be accepted.
4.
GJF, Problem 10-15 (p. 459)
“Country Wallpapers is considering investment in one of three mutually exclusive
projects, E, F and G. The firm’s cost of capital is 15%, and the risk-free rate,
RF
, is 10%. The firm has gathered the following basic cash flow and risk index data
for each project.
Project E
$15,000
Initial Inv.
Year (t)
Project F
$11,000
Project G
$19,000
Net cash inflows ( CFt )
1
2
3
$6,000
6,000
6,000
$6,000
4,000
5,000
$4,000
6,000
8,000
3
4
Risk Index
(a)
(b)
RI j
6,000
1.80
2,000
1.00
12,000
0.60
Find the NPV of each project using the firm’s cost of capital. Which project
is preferred in this situation?
The firm uses the following equation to determine the risk-adjusted
discount rate,
RADR j , for each project j.
RADR j  RF  [ RI j  (r  RF ]
Where
RF = risk-free rate of return
RI j = risk index for project j
r = cost of capital
Substitute each project’s risk index into this equation to determine its
RADR.
(c)
(d)
Use the RADR for each project to determine its risk-adjusted NPV. Which
project is preferable in this situation?
Compare and discuss your findings in parts (a) and (c). Which project
would you recommend that the firm accept?
Answer:
(a)
6,000 [1  (1.15) 4 ]
NPVE 
 15,000  $2,129.87
0.15
NPVF 
6,000 4,000 5,000 2,000



 11,000  $1,673.05
1.15 (1.15) 2 (1.15)3 (1.15) 4
NPVG 
4,000 6,000 8,000 12,000



 19,000  $1,136.29
1.15 (1.15) 2 (1.15)3 (1.15) 4
Project E, with the highest NPV, is preferred.
(b)
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RADRE  RF  [ RI E  (r  RF ]  0.10  [1.80  (0.15  0.10)]
 0.19
RADRF  0.10  [1.00  (0.15  0.10)]  0.15
RADRG  0.10  [0.06  (0.15  0.10)]  0.13
(c)
6,000 [1  (1.19) 4 ]
NPVE 
 15,000  $831.51
0.19
NPVF  $1,673.05 (As in part (a))
NPVG 
Rank:
1
2
3
4,000 6,000 8,000 12,000



 19,000  $2,142.93
1.13 (1.13) 2 (1.13)3 (1.13) 4
Project
G
F
E
(d)
After adjusting the discount rate, even though all projects are still acceptable,
the ranking changes. Project G has the highest NPV and should be chosen, because the
discount rate used to find this NPV reflects the risk of the project.
Discussion question (student should read and understand this question, will not be
discussed in the tutorial):
1.
Consider the following statement:
“There are benefits to investors from portfolio diversification; therefore firms
consisting of a highly diversified collection of assets are more attractive to
investors than firms that are relatively non-diversified in terms of their assets”.
Is this statement valid? Give a reason for your answer. If the statement were
valid, what would be the implications for capital budgeting by firms?
Answer:
This statement is generally considered invalid. The simple reason for this is that
investors can cost effectively diversify their own portfolios by investing in a number
and variety of assets. Therefore they do not need firms to diversify for them and will
not value firms more highly simply because their assets are more diversified.
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If the statement were valid, this would have important implications for capital
budgeting. In particular, the NPV of a project could not be evaluated in isolation from
the firm’s other projects and existing assets. For example, a project would have a
different value depending on whether it is undertaken by a single-project firm or a
multi-asset firm. In fact if the statement were valid, the market value of a firm could
not be calculated as the sum of the individual market values of its assets (a fundamental
assumption of most corporate finance).
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