School of Business MBA 643 Week 2: Capital Budgeting Decision Rules Question 1 Cash Flows ($) Project C0 C1 C2 C3 C4 A -5000 1000 1000 3000 0 B -1000 0 1000 2000 3000 C -5000 1000 1000 3000 5000 a. What is the payback period on each of the following projects? b. Given that you wish to use the payback rule with a cutoff period of two years, which projects would you accept? c. If you use a cutoff period of three years, which projects would you accept? d. If the cost of capital is 10%, which projects have a positive NPV? e. If a firm uses a single cutoff period for all projects, it is likely to accept too many short-lived projects. True or False? f. Consider standard projects. If the firm uses the discounted payback rule, will it accept any negative NPV projects? Will it turn down positive NPV projects? Explain. Question 2 Mr. Cyrus Clops, the president of Giant Enterprise, has to make a decision between two possible investments: CASH FLOWS ($ THOUSANDS) PROJECT C0 C1 C2 IRR A -400 250 300 23% B -200 140 179 36% The opportunity cost of capital is 9%. Mr. Clops is tempted to take B, which has higher IRR. a) Calculate the NPV for each project. b) Is IRR an appropriate decision rule here? Explain to Mr. Clops why. c) Show him how to adapt the IRR rule to choose the best project. Question 3 Borghia Pharmaceuticals has $1 million allocated for capital expenditures. The opportunity cost of capital for each project is 11%. a) Which of the following projects should the company accept to stay within the $1 million budget? b) How does the budget limit cost the company in terms of its market value? Project Investment ($ thousands) NPV ($ thousands) IRR 1 300 66 17.2% 2 200 -4 10.7% 3 250 43 16.6% 4 100 14 12.1% 5 100 7 11.8% 6 350 63 18% 7 400 48 13.5%