M4 - Practical Application 2

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Louisiana State University, Shreveport *

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Jan 9, 2024

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MBA702: Fall 2023 - AP2 M4: Practical Application 2 Feedback comments Great!! You performed well in completing the rate of return calculations, as well as the calculations involving the various methods of capital budgeting evaluation. You also demonstrated an understanding of the IRR, and also the consideration of changes impacting the NPV. The only corrections included : # 1 (add values for the total) ; Project C's NPV is negative and its PI (and double decision deductions were not made) , and to clarify 8 a (ii), the NPV does take into account a reinvestment rate (as later stated, the cost of capital - no points deducted) Answers are highlighted in blue. Setup: Baker Corp. has several new projects that look attractive, but some are riskier than the firm's past projects. Baker has received a major inflow of cash from a venture capital firm, in exchange for 25% of the firm's closely held stock. The VC firm has asked Baker managers to "run the numbers" to examine both the market outlook and the expected returns on each of the projects they are considering. The cash infusion will not cover all the proposed projects; Baker and its new investors need to know which projects should be approved. 1. Based on Baker's earnings history over the past 10 years across a variety of projects, which have covered various states of the economy, the venture capital execs want Baker to estimate their overall returns. Given the following estimates of economy over the next several years, determine Baker's expected rate of return. (6 pts) Note, this type of development firm has much higher than normal returns under normal and boom conditions. The probability of each state of the economy reflects the current situation, not necessarily historic market conditions for the firm. State of the Economy Current Probability of State of the Economy Rate of Return if State Occurs Boom 20% 23.0% Normal 55% 10.0% Recession 25% -21.0% Expected return for “average” company project (based on assumed economic probabilities) = Boom: 20%*23% = 4.6% Correction: add values for the total Normal: 55%*10% = 5.5% Recession: 25%*-21% = -5.25% 2. Historically, Baker projects have had an average beta of 1.25, which indicates the higher risk levels for the firm. Assuming the market risk premium (MRP) currently estimated to be 6% and the risk-free rate is 5.53%, what is the required return for an "average" Baker project using based on its average project beta? Show the average required return to 2 decimal places (x.xx%). (6 pts) Expected return for “average” company project (based on current estimated MRP) = R=Rf + (beta * MRP) 1

MBA702: Fall 2023 - AP2 M4: Practical Application 2 Rf = 5.53% Beta = 1.25 MRP = 6% R= 5.53% + (1.25 * 6%) R= 5.53% + 7.5% R= 13.03% 3. The potential projects that Baker is considering have the following expected cash flows. Each project has its own unique risk and as such, the beta on each project is given. Using the data from #2 for the risk-free rate and market risk premium, what is the required percentage return for each of the projects? Show the required returns to 2 decimals, that is xx.xx%. You will use these rates when analyzing each project in the next part of the assignment, these are the required rates of return for Problems 4-6) . (8 pts) R=Rf + (beta * MRP) Rf = 5.53% MRP = 6% Project A Project B Project C Project D Beta 1.3 0.9 1.1 1.6 Required Return (show work) R= 5.53% + (1.3* 6%) =.0553+ (1.3*.06) = .0553 + .078 = .1333 = 13.33% R= 5.53% + (0.9* 6%) =.0553+ (0.9*.06) = .0553 + .054 = .1093 = 10.93% R= 5.53% + (1.1* 6%) =.0553+ (1.1*.06) = .0553 + .0660 = .1213 = 12.13% R= 5.53% + (1.6* 6%) =.0553+ (1.6*.06) = .0553 + .0960 = .1513 = 15.13% NOTE: When a firm has projects that differ in risk (beta) than the "average" for the company, then the firm's overall required return (from Problem 2) isn't applicable. Each project needs to provide a return greater than or equal to its unique risk-adjusted required return. THE RATES CALCULATED FOR PROJECTS A – D IN #3 ARE THE REQUIRED RETURNS FOR EACH FOR THE FOLLOWING: Use for Problems 4-7. For each project, calculate the NPV, IRR, profitability index (PI) and the payback period. For each capital budgeting decision tool, indicate if the project should be accepted or rejected, assuming that each project is independent of the others. Important Note: The venture capital folks, when considering payback period, have a firm maximum payback period of four years. This 4-year payback period has no impact on other capital budgeting analysis techniques, each is to be considered on its own. In other words, yes, all cash flows need to be considered for NPV, IRR, and PI. Expected cash flows for the four potential projects that Baker is considering as shown below (each project ends when its cash flows end): Year Project A Project B Project C Project D 0 -$4,000,000 -$3,000,000 -$6,000,000 -$7,250,000 1 $1,000,000 $300,000 $1,500,000 $2,500,000 2 $1,000,000 $500,000 $1,500,000 $3,000,000 2

MBA702: Fall 2023 - AP2 M4: Practical Application 2 3 $1,000,000 $500,000 $2,500,000 $2,000,000 4 $1,000,000 $750,000 $2,500,000 $1,500,000 5 $800,000 $750,000 $1,500,000 6 $0 $750,000 7 $800,000 $750,000 8 $300,000 $750,000 9 $750,000 10 $750,000 I have provided a suggested template for your final answers. Below the grid is where you should show all your required backup calculations ( this means your cash flow register inputs, the interest rate, PI calculation and cumulative cash flows for payback ). If you are working this in Excel, feel free to submit your Excel sheet, where the equations in the cells will provide the required backup. Be sure to clearly indicate the required rate of return for each project (you calculated each in Problem 3). Remember that each capital budgeting method should be calculated and analyzed on a stand-alone basis. Year Project A Project B Project C Project D Point s Req. Return (use 2 decimals xx.xx%) 13.33% 10.93% 12.13% 15.13% 6 4a NPV (to nearest $1) -$174,462 -$637,952 $114,539 $90,679 2 4 b NPV accept/reject A A A A 4 5a IRR (xx.xx%) 11.77% 15.15% 11.31% 15.72% 2 5 b IRR accept/reject A A R A 4 6a PI (show 2 decimals, x.xx) 0.96 1.21 1.96 1.01 2 6 b PI accept/reject R A A A 4 7a Payback Period (x.x years) 4 years 5.3 years 3.2 years 2.9 years 2 7 b Payback accept/reject A R A A WORK SHOWN ON NEXT PAGES 3

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MBA702: Fall 2023 - AP2 M4: Practical Application 2 Project A Required Return = 13.33% CF0 -$4,000,000 CF1 $1,000,000 F01= 4 CF2 $800,000 F02= 1 CF3 $0 F03= 1 CF4 $800,000 F04= 1 CF5 $300,000 F05=1 4a. NPV= -$174,462.38 4b. accept because >0 5a. IRR= 11.7790 5b. accept because > return 6a. PI= 3,825,537.619/4,000,000= 0.9564 6b. reject because <1 Years Cash Flow Cumulative Cash Flow 0 ($4,000,000) ($4,000,000) 1 $1,000,000 ($3,000,000) 2 $1,000,000 ($2,000,000) 3 $1,000,000 ($1,000,000) 4 $1,000,000 $0 5 $800,000 $800,000 6 $0 $800,000 7 $800,000 $1,600,000 8 $300,000 $1,900,000 7a. Payback Period = 4 years project lasts 8 years firm’s maximum payback period= 4 years 7b. accept because not longer than max payback period (continues on next page) 4

MBA702: Fall 2023 - AP2 M4: Practical Application 2 Project B Required Return = 10.93% CF0 -$3,000,000 CF1 $300,000 F01= 1 CF2 $500,000 F02= 2 CF3 $750,000 F03= 7 4a. NPV= -$637,951.57 4b. accept because >0 5a. IRR= 15.1468 5b. accept because > rate of return 6a. PI= 3,637,951.566/3,000,000= 1.2127 6b. accept because > 1 Years Cash Flow Cumulative Cash Flow 0 ($3,000,000) ($3,000,000) 1 $300,000 ($2,700,000) 2 $500,000 ($2,200,000) 3 $500,000 ($1,700,000) 4 $750,000 ($950,000) 5 $750,000 ($200,000) 6 $750,000 $550,000 7 $750,000 $1,300,000 8 $750,000 $2,050,000 9 $750,000 $2,800,000 10 $750,000 $3,550,000 7a. Payback Period= 200,000/750,000= 0.2667+5= 5.2667 project lasts 10 years firm’s maximum payback period= 4 years 7b. reject because longer than max payback period (continues on next page) 5

MBA702: Fall 2023 - AP2 M4: Practical Application 2 Project C Correction: NPV is negative and its PI (and double decision deductions were not made) Required Return = 12.13% CF0 -$6,000,000 CF1 $1,500,000 F01= 2 CF2 $2,500,000 F02= 2 4a. NPV= -$114,538.64 4b. accept because >0 5a. IRR= 11.3069 5b. reject because < rate of return 6a. PI= 5,885,461.365/3,000,000= 1.9618 6b. accept because >1 Years Cash Flow Cumulative Cash Flow 0 ($6,000,000) ($6,000,000) 1 $1,500,000 ($4,500,000) 2 $1,500,000 ($3,000,000) 3 $2,500,000 ($500,000) 4 $2,500,000 $2,000,000 7a. Payback Period= 500,000/2,500,000= 0.2000+3= 3.2 project lasts 4 years firm’s maximum payback period= 4 years 7b. accept because shorter period of time than max payback period (continues on next page) 6

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MBA702: Fall 2023 - AP2 M4: Practical Application 2 Project D Required Return = 15.13% CF0 -$7,250,000 CF1 $2,500,000 F01= 1 CF2 $3,000,000 F02= 1 CF3 $2,000,000 F03= 1 CF4 $1,500,000 F04= 2 4a. NPV= -$90,679.25 4b. accept because >0 5a. IRR= 15.7243 5b. accept because > rate of return 6a. PI= 7,340,679.254/7,250,000= 1.0125 6b. accept because >1 Years Cash Flow Cumulative Cash Flow 0 ($7,250,000) ($7,250,000) 1 $2,500,000 ($4,750,000) 2 $3,000,000 ($1,750,000) 3 $2,000,000 $250,000 4 $1,500,000 $1,750,000 5 $1,500,000 $3,250,000 7a. Payback Period= 1,750,000/2,000,000= .8750+2= 2.8750 project lasts 5 years firm’s maximum payback period= 4 years 7b. accept because short time period than max payback period (continues on next page) 7

MBA702: Fall 2023 - AP2 M4: Practical Application 2 8. Discussion (No outside sources required all necessary information has been presented in Module 4 in Moodle) a) Using what you have learned in the lecture notes and having just analyzed each of the projects using the four key capital budgeting techniques, describe the reinvestment assumptions for each of the methods. (2 pts) Hint, the reinvestment rate assumptions have to do with how (if) the cash flows are discounted during analysis. i. NPV - The reinvestment rate will not affect the NPV as the NPV does not take into account any reinvestment rate but instead bases reinvestment on the cost of capital (assuming average risk) or the firms required rate of return. ii. IRR - The IRR assumes that all reinvestments will happen at the IRR rate of return for the lifetime of the project. If the reinvestment rate becomes too high or is not feasible, the project will fail. If the reinvestment rate is too low, the project will become unprofitable and may be dropped. IRR can be deceiving as a high IRR does not always mean the project will be sustainable or profitable. iii. Profitability Index (PI) - The PI also assumes reinvestment based on the firm required rate of return. PI and NPV take into account the discounted cash flows and this required rate of return. iv. Payback Period – The payback period does not assume any reinvesting. The present and future cash flows are all considered in the same manner with no regard for reinvestment of funds or the discounting of cash flows. The payback period simply sums all cash flows. b) For an independent project, which of the capital budgeting analysis techniques will always have the accept/reject decision, and why. Be precise in your explanation of "why" the techniques would agree. Hints: Keep it simple, don't go down the "but what if ..... " road. Independent projects - accepting one doesn't mean you have to reject another one. Don't assume financial constraints (you could theoretically fund all viable projects). Assume "normal" cash flows (only 1 sign change in other words, the outlay is considered negative and all future cash flows are positive), so that there is only a single IRR . (2 pts) When looking at independent projects IRR works well because accepting one project does not affect accepting another project. IRR is defined as “that discount rate such that the PV of future cash flows is exactly equal to initial investment. So, IRR determines the exact discount rate that will result in an NPV of zero. The lower the discount rate, the higher the PV of future cash flows. So, if the IRR is equal to the discount rate for the project, the project will have an NPV of zero, meaning that the firm will not increase the wealth of its shareholders. Firms should always accept projects with a positive NPV (if independent), meaning it has an IRR greater than its discount rate. 8

MBA702: Fall 2023 - AP2 M4: Practical Application 2 c) How would a change in the required rate of return affect the project’s calculated internal rate of return (IRR)? Explain. Would the accept/reject decision change using the IRR analysis method? Explain. (2 pts) A change in the required rate of return will not changes the project’s calculated internal rate of return. The IRR is calculated based of the rate needed to cover the project’s cost of capital. If the required rate of return were to be lower, the NPV for the project would go up and the project would be accepted. If the required rate of return was moved above the IRR, then the NPV would become negative and the project would be rejected as the total investment would not be profitable. d) Think about changes that happen in a project once it has been accepted and moving forward. Here are 3 potential scenarios. For each, describe what you expect to happen to a project's expected NPV, and WHY that is your expectation. (2 pts for each of the following). As MBA students, just being able to calculate NPV isn’t sufficient. You should be able to consider what the effects of various market or project changes on the project’s viability. LOOK AT EACH SITUATION INDIVIDUALLY AND ASSUME THAT THERE ARE NO OTHER CHANGES FOR THE FIRM. i. Your firm has a project that has been tentatively accepted for development, assuming a required rate of return of 13%. That required rate of return was estimated over a year ago, before the FED began its interest rate hikes. The risk free rate has increased by .5% from that used in the original projection. The increase in the risk-free rate raises the discount rate, which reduces the present value of the project's future cash flows. This decrease in present value leads to a lower expected NPV. This is due to NPV being the projected cash flow divided by 1 + the discount rate raised to the power of the number of years of future cash flow. When the denominator of the equation changes the quotient will decrease. ii. Your firm recently acquired a company that has a new technology that will extend the life of a current project by 5 years. The project had an expected remaining life of 5 years, now the remaining life is 10 more years, with original forecast annual cash flows of $250,000 per year remaining steady over the full time period. The extension of the project's life allows for additional years of positive cash flows, increasing the total present value of the cash flows and leading to a higher expected NPV. This is due to NPV being the result of calculating the current value of a future stream of payment. In other words it is today’s value of the expected cash flows less today’s value of invested cash. So naturally, if amount of cash flows increase the NPV will increase. Correction: the NPV does take into account a reinvestment rate (as later stated, the cost of capital - no points deducted) iii. It has just been discovered that the site of one of your firm’s projects will require a major cleanup and remediation at the end of the project’s life (in 5 years). 9

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MBA702: Fall 2023 - AP2 M4: Practical Application 2 Discovering the need for a major cleanup and remediation at the end of a project's life can significantly impact the project's expected NPV. In this case, the expected NPV is likely to decrease. The cleanup and remediation costs represent an additional expense that was not originally accounted for in the project's cash flow projections. These added costs reduce the project's overall profitability, leading to a lower NPV as the project's expected cash flows are negatively affected by the cleanup expenses. e) Your firm is looking at three mutually exclusive projects . Describe how you would decide which project(s) to accept, be very clear on which capital budgeting techniques you would use and how you make your decision. (2 pts) The lecture notes cover this one, review as needed. When a firm decides between mutually exclusive projects, they must accept one and reject the others. In order to decide which project to accept the firm must calculate and analyze the NPVs of each project. This is because it provides clear accept/reject data and considers the scale and scope of the project. The firm would need to choose the project with the highest NPV. 10

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6.Calculate the project's Modified Internal Rate of Return (MIRR). What critical assumption does the MIRR make that differentiates it from the IRR? TIP : look for the definition of Modified Internal Rate of Return, and then do it in excel, easy !!! Year Net Cash flow Future Value of Net Cash flow 0 -$20.8 example 1 $4.5 $7.97 (n=6, i=10%)=fv(.1,6,,4.5) 2 $6.3 (n=5, i=10%) 3 $5.2 (n=4, i=10%) 4 $3.9 (n=3, i=10%) 5 $2.1 (n=2, i=10%) 6 $1.3 (n=1, i=10%) 7 $0.5 (n=0, i=10%) Sum = $XX.XX MIRR = ( in excel ) Rate ( 7,-20.8, xx.xx) 7.Where does the value of MIRR fall relative to the discount rate and IRR?

From the problem below :1. For capital budgeting purposes, what is the net investment in the new, high-performing machine?A. P186,400B. P185,000C. P169,600D. P148,000 2. What is the payback period?A. 4.49 yearsB. 5.24 yearsC. 5.76 yearsD. None from the choices 3. Compute the new, high-performing machine's net present value.A. P1,200B. P15,892C. P28,025D. P6,729

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**Please solve using Excel and show formulas.** Consider the following projects: Project Cash Flows A -4 5 2.3 0 0 1,000 B -5,600 2,800 2,800 5,800 2,800 2,800 C -7,000 2,800 2,500 0 2,800 2,800 Question: What is the payback period for Project C? Multiple Choice 3.4 3.9 3.2 3.6 3.8

Value/other investment criteria (i Saved Help Save Consider the following two projects: Cash flows Project A Project B -$270 CO -$270 С1 115 143 C2 115 143 Сз 115 143 C4 115 a. If the opportunity cost of capital is 10%, which of these two projects would you accept (A, B, or both)? b. Suppose that you can choose only one of these two projects. Which would you choose? The discount rate is still 10%. Which one would you choose if the cost of capital is 15%? d. What is the payback period of each project? e. Is the project with the shortest payback period also the one with the highest NPV? f. What are the internal rates of return on the two projects? g. Does the IRR rule in this case give the same answer as NPV? h-1. If the opportunity cost of capital is 10%, what is the profitability index for each project? h-2. Is the project with the highest profitability index also the one with the highest NPV? h-3. Which measure should you use to choose between the projects? Complete this question by…

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Question 3 A firm is looking to evaluate the income coming from a project. The project has alowest possible income of $1,036.31, a likely income of $2,113.29 and a maximum income of $2,904.68. What is a the risk mitigated income that a firm should use their analysis? Enter your answer below (no $ sign), and show your work in your drobox submission. Your Answer:

Mc Graw Hill Risk and Capital Budgeting AA Fill in the blank: Scenario analysis is made up of several Correct Michael Scenarios Michael We have created various scenarios each with a forecast for our expected sales volume, revenues, expenses, risks, etc. At a high level, here are how each of the scenarios looks like. Calculate NPV for Scenario A. Use the information provided on the right. Round to the nearest whole number. Submit Enter a response then click Submit below $0 Scenarios Area 1.1 Scenario Comparison ($) Scenario A Scenario B Scenario C Initial Investment 2,000,000 2,000,000 2,000,000 Expected interest rate: 12% Forecasting period: 5 years PV annuity factor: 3.6048 Annual Net Income 545, 100 426,995 1,644,385 Annual Cash Flow 656,890 -493, 005 2,564,385 NPV -3,777, 184 7,244,095 Return to Activity Score Materials

Which of the following is FALSE regarding various methods of project analysis? Both NPV and IRR consider the time value of money. Average Accounting Return ignores the time value of money. Payback focuses on liquidity. O Profitability Index is able to rank projects in the situation of capital rationing. () Payback considers the time value of money. Next Page Page 17 of 3 Previous Page Submit Quiz O of 30 questions saved

Please help answer From Question 3.1 to 3.5 REQUIREDStudy the information provided below and calculate the following:3.1 Payback Period of Project A (answer expressed in years, months and days). 3.2 Accounting Rate of Return (on average investment) of Project B (answer expressed totwo decimal places).3.3 Net Present Value of both projets (amounts rounded off to the nearest Rand). 3.4 Benefit Cost Ratio of Project A (answer expressed to three decimal places). 3.5 Internal Rate of Return of Project B (answer expressed to two decimal places). INFORMATIONThe following information relates to two possible capital expenditure projects being considered by EdamLtd. Because of capital rationing, only one project can be accepted.Project A Project BInitial cost R800 000 R800 000Expected useful life 5 years 5 yearsAverage annual profit R80 000 R80 000Expected net cash inflows: R RYear 1 240 000 240 000Year 2 260 000 240 000Year 3 280 000 240 000Year 4 220 000 240 000Year 5 200 000 240 000The…

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