CHAPTER 14: CAPITAL BUDGETING Homework 4.7, Chapter 14 Assume that you are the C

Question

CHAPTER 14: CAPITAL BUDGETING Homework 4.7, Chapter 14 Assume that you are the CFO at Porter Memorial Hospital. The CEO has asked you to analyze two proposed capital investments-Project X and Project Y. Each project requires a net investment outlay of $25,000, and the cost of capital for each project is 12 percent. The projects' expected net cash flows are as follows: Project X Project Y Year 12,000 8,000 8,000 5,000 8,000 8,000 8,000 8,000 4 a. Calculate each project's payback period, net present value (NPV), and internal rate of return (IRR). b. Which project(s) is/are financially acceptable? Explain your answer.

Explanation / Answer

(a) Payback period is the time period within which the Initial investment required for the Project is recover through cash flows:

For Project X: The Initial Investment is recovered somewhere in the third year.

Payback period is: 2 + (5000/8000) = 2.6250 years = 2 years and 228 days.

For Project Y: Payback period = 3 + (5000/8000) = 3.6250 yaers = 3 years and 228 days

Net Present value (NPV) of the project is the Differnce between the Present Value of the future Cashflows of the project and the Initial Investment made for the project.

For ProjectX:

Discounting factor @ 12%

Initial Outflow: $25000

Therefore NPV: PV of inflows - Initial outflow: $ 963.82

For Project Y:

Initial Outflow: $25000

Therefore NPV: PV of inflows - Initial Outflow = (-) 700.80

Internal rate of return (IRR) is the actual return of the project. It is the rate at which outflows = inflows.

It is calculated using a Financial Calculator or It can be calculated by Trial or Error basis (guessing basis) i.e we have to guess a rate and then calculate the Present value of Inflows, and then equate it with the Initial outflow.

I have done the IRR calculation using Financial calculator.

For Project X: IRR = 14.09%

For Project Y: IRR = 10.66%

(b) Project X is financially acceptable because it has a Positive NPV, while Project Y is not acceptable because it has negative NPV.

Year Cash flow

Discounting factor @ 12%

Present value 1 12000 0.8929 10714.29 2 8000 0.7972 6377.55 3 8000 0.7118 5694.40 4 5000 0.6355 3177.58 Total PV of Inflow: 25963.82

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