Preparatory Question Set: Capital Budgeting $($Module V$)$

Address the following questions regarding the capital budgeting process:

What are the three steps in the capital budgeting process?

What does $$Free Cash Flow $($FCF$)$ mean?

When estimating the FCF of a project, you are expected to estimate $$incremental$$ FCF $$ explain what the phrase $$incremental$$ means and why you need to calculate the $$incremental$$ FCF to evaluate a project?

What three attributes of these incremental FCFs matter? How are these attributes incorporated in the capital budgeting process?

What is the difference between $$independent$$ and $$mutually exclusive$$ projects? Fill$-$in$-$the$-$blanks below assuming the manager$$s goal is to maximize stockholder wealth.

Accepting an independent project maximizes stockholders wealth if accepting it $\_\_\_\_\_\_\_$ stockholder wealth.

Consider two mutually exclusive projects $$ Project $1$ and Project $2.$

Impact of Project $1$ on stockholder wealth will be measured by how much it $\_\_\_\_\_\_\_\_$

Impact of Project $2$ on stockholder wealth will be measured by how much it $\_\_\_\_\_\_\_\_$

Stockholder wealth will be maximized by accepting Project $1$ if it $\_\_\_\_\_\_\_\_\_\_\_$ stockholder wealth $\_\_\_\_\_$ than that by Project $2$

Both independent and mutually exclusive projects can be evaluated using various measures $($metrics$),$ four of which are NPV$,$ IRR, Payback period, and Profitability Index.

Describe what each metric is calculating using the simplest possible words.

What is the formula you will use to calculate each metric?

How is each metric used to make decisions for independent projects? Mutually exclusive projects?

The four metrics $$ NPV$,$ IRR, Payback period, and Profitability Index $$ do not always yield the same decisions.

Why is NPV the primary capital budgeting decision criterion for both types of projects? Explain.

which situations do the other metrics $($IRR$,$ Payback period, and Profitability Index$)$ fail to maximize stockholder wealth if projects are independent? Explain why.

which situations do the other metrics fail to maximize stockholder wealth if projects are mutually exclusive? Explain why.

Given the limitations of IRR and Payback, why are they so popular?

Describe in words how an NPV profile is constructed. How do you determine the intercepts for the x$-$axis and the y$-$axis of the NPV profile?

Suppose you draw the NPV profile of two projects on the same graph. What is the crossover rate, and how does it interact with the cost of capital to determine whether or not a conflict exists between NPV and IRR? Explain.

When two mutually exclusive projects are being compared, explain why the short$-$term project might be ranked higher under the NPV criterion if the cost of capital is high, whereas the long$-$term project might be deemed better if the cost of capital is low. Would changes in the cost of capital ever cause a change in the IRR ranking of two such projects? Why or why not? $8.$ Answer the following questions regarding the $($incremental$)$ free cash flows of a project $8.$ Answer the following questions regarding the $($incremental$)$ free cash flows of a project

$($Instructor Problem $$ no solutions will be provided$)$ Orange County Industry $($OCI$)$ is an unlevered firm and has $$10$ million in internal capital that it can invest in one of four mutually exclusive capital investment projects, which have cash flows as shown in Table below $($all numbers are in thousands$).$

Project

Year $0$

Year $1$

Year $2$

Year $3$

A

$-$$$10,000$

$$12,000$

$$4,200$

$$600$

B

$-$$$10,000$

$$5,500$

$$10,300$

$$3,100$

C

$-$$$10,000$

$$5,670$

$$7,260$

$$8,670$

D

$-$$$10,000$

$$2,330$

$$5,670$

$$14,670$

Define NPV$,$ IRR, Payback, and Profitability Index. How does one make decisions using these measures if projects are i$)$ Independent and ii$)$ Mutually exclusive

Draw an NPV profile of the four projects. Rank the company$$s four projects using the NPV criteria under two discount rates $10\%$ and $35\%$

Rank the company$$s four projects according under the other capital budgeting criteria $($IRR$,$ Payback, and discounted payback$)$ under two discount rates $10\%$ and $35\%$

Why do the rankings differ under the four criteria? What are the correct rankings, i$.$e$.,$ rank the projects based on the wealth they add to the shareholders?

$($End$-$of$-$chapter numerical problem $12\mathrm{.}15)$ The Pinkerton Publishing Co$.$ is considering two mutually exclusive expansion plans. Plan A calls for the expenditure of $$50$ million on a large$-$scale, integrated plant that will provide an expected cash flow stream of $$8$ million per year for $20$ years. Plan B calls for the expenditure of $$15$ million to build a somewhat less efficient, more labor$-$intensive plant that has an expected cash flow stream of $$3\mathrm{.}4$ million per year for $20$ years. The firm$$s cost of capital is $10\%.$

Calculate each project$$s NPV$,$ IRR, and Profitability Index.

Why do you find differences in rankings across these methods?

$($End$-$of$-$chapter numerical problem $12\mathrm{.}12)$ After discovering a new gold vein in the Colorado mountains, CTC Mining Corporation must decide whether to go