PROJECTS AND THEIR VALUATION

Projects and their Valuation: Mini Case



Projects and their Valuation: Mini Case

a.

Capital budgeting is a process of evaluating projects through different techniques and deciding which ones to include in the capital budget and invest. The major techniques or methods of capital budgeting are net present value, payback period, discounted payback period. internal rate of return and modified internal rate of return.

b.

Independent projects are projects whose cash flows don't affect one another and mutually exclusive projects are projects that if one project is taken on, the other must be rejected.

c.

1. Net present value is defined as a way to improve the effectiveness of project evaluations through the use of discounted cash flow techniques. The project is accepted for the investment if the NPV is positive, while the project is rejected if it is negative.

WACC =

10%

Franchise S

Time period:

0

1

2

3

Cash flow:

(100)

70

50

20

Disc. cash flow:

(100)

64

41

15

Franchise S; NPV = $19.98

Franchise L

Time period:

0

1

2

3

Cash flow:

(100)

10

60

80

Disc. cash flow:

(100)

9

50

60

Franchise L; IRR = $18.78%

2. The rationale behind that assertion arises from the idea that all such projects add wealth, and that should be the overall goal of the manager in all respects. If strictly using the NPV method to evaluate two mutually exclusive projects, you would want to accept the project that adds the most value (i.e. the project with the higher NPV). Hence, if considering the above two projects, you would accept both projects if they are independent, and you would only accept Project S if they are mutually exclusive.

3. Yes, NPV changes with the change in the cost of capital. A project have a positive with low cost of capital, while the same project may have negative NPV if the cost of capital is large.

d.

1. The Internal Rate of Return is the discount rate at which the present value of a project's cash inflows equals its outflows. It is the discount rate that forces the PV of the inflows to equal the initial cost. In other words, the IRR is the interest rate that forces NPV to zero. The IRR's for Franchises S and L are shown below, along with the data entry for Franchise S.

 

Expected

 

net cash flows

Year (t)

Franchise S

Franchise L

0

($100)

($100)

1

70

10

2

50

60

3

20

80

Franchise S; IRR = 23.56%

Franchise L; IRR = 18.13%

2. If you invest in a bond, hold it to maturity, and receive all of the promised cash flows, you will earn the YTM. Exactly the same concepts are employed in capital budgeting when the IRR method is used. The nature of the congruence of the NPV and IRR methods is further detailed in a latter section of this model.

3. Internal Rate Return is the rate at which the present value of a project's net cash flows is equivalent to the initial outlay and it also indicates the rate return of a project. To accept a project, the internal rate of return has to be ...