Capital Budgeting: Case Study (Answering questions) - Math Problem Example

From the given data, it can be seen that Project ‘p’ has a higher NPV as compared to Project ‘q’. Hence, if NPV is chosen as the criterion, Project ‘p’ must be preferred. However, it is also seen that Project ‘q’ has a higher IRR. Thus, form IRR point of view ‘q’ is the preferred project. Overall, there is a large difference between NPVs of the two projects while there is a smaller difference between their IRRs. Hence, Project ‘p’ should be selected over Project ‘q’. Moreover, IRR ranking is misleading here because the base investment (initial cash outflow) in the two projects is not the same. The cash outflow in Project ‘p’ ($200) is twice that of project ‘q’ ($100). Hence, it would not be appropriate to compare the two projects on IRR basis. 2. Let ‘S’ be the periodic saving, ‘i’ be the interest rate, ‘P’ be the annual payments to be ensured, ‘n’ be the number of years for which savings are done and ‘N’ be the number of years for which payments are to be ensured. According to the given data, S has to be calculated i=4% P=$30,000 n=20 years N=15 years Now, Future value of all savings at the end of 65 years= Present Value of all payments at the end of 65 years i.e. S[(1+i)^n-1]/i = P (1-(1/(1+i)^N))/i i.e. S[(1+.04)^20-1]/.04 = 30000 (1-(1/(1+.04)^15))/.04 i.e. S= $11,201.25 Hence, the annual savings must be $11,201. 3. Table 3.1 depicts the Interest paid, Principal Paid and Principal Balance at the end of first 10 years. Here, Interest paid is calculated as 10% of principal balance in the previous year. The Principal paid is calculated as the difference of Yearly Installment and Interest Table 3.1: Yearly Installment Plan at 10% rate of interest throughout Year Interest paid Principal paid Principal balance 0 0 0 200000 1 20000 1,215.85 198784.1503 2 19878.41503 1,337.43 197446.7157 3 19744.67157 1,471.18 195975.5377 4 19597.55377 1,618.30 194357.2418 5 19435.72418 1,780.13 192577.1163 6 19257.71163 1,958.14 190618.9783 7 19061.89783 2,153.95 188465.0265 8 18846.50265 2,369.35 186095.6795 9 18609.56795 2,606.28 183489.3977 10 18348.93977 2,866.91 180622.4879 paid. Principal balance is calculated as difference of previous year’s Principal balance and current year’s Principal paid. The yearly installment can be calculated by using formula for Present value or ‘pmt’ function in excel. It comes out as $21,215. The principal balance at the end of 1 year comes out as $198,784 and at the end of 10 years as $180,622. If mortgage rates drop to 8%, the yearly installments after 4th year are calculated using principal balance at the end of 4th year. This comes out as $17,979. Table 3.2 depicts Table 3.2: Yearly Installment Plan at 10% rate of interest till 4th year and 8% thereafter Year Interest paid Principal paid Principal balance 0 0 0 200000 1 20000 1,215.85 198784.1503 2 19878.41503 1,337.43 197446.7157 3 19744.67157 1,471.18 195975.5377 4 19597.55377 1,618.30 194357.2418 5 15548.57934 2,430.85 191926.3911 6 15354.11129 2,625.32 189301.0724 7 15144.08579 2,835.34 186465.7282 8 14917.25826 3,062.17 183403.5565 9 14672.28452 3,307.15 180096.411 these changes. Now, if $3000 is paid to refinance this change, the value of Net Present Value of cash outflow at the end of 4th year is given by the sum of Future value of installments up till 4th year at 10%, Present value of installments from 4th year to 9th year at 8% and $ 3000. This is equal to $173,249. If $ 3000 is not paid and rather invested in CD at 6% return, the value of Net Present Value of cash outflow at the end of 4th year is given by [Future value of installments up till 4th year at 10% + Present value of installments from 4th year to 9th year at 10% - $ 3000[(1.06)^5-1]. This is equal to $177,872. Hence, refinancing the mortgage is a better option as the NPV of net cash outflows is lower. It is assumed here that after the 9th year, the house is sold or the returns from it are similar in both options. 4. The efficiency of the compensation plan is dependent upon the expected revenue of the hospital. If the expected revenue is significantly above $100,000, the plan is good enough. It directly gives 70% of the revenue above $100,000 to the hospital without caring for expenses. However, if the expected revenue is below or close to $100,000, the plan is not beneficial for the hospital. Another drawback of the plan is that, doctors may be tempted to cut down on expenses hence impacting the quality of service. An alternative plan can be used here. In this plan, expenses are born by the hospital only. The doctor gets a fixed salary if the revenue is below a threshold. If the revenue exceeds threshold, the doctor gets a percentage of the revenue above threshold. This would eliminate the drawbacks mentioned above and retain the performance based component of the plan. 5. a. If Taggart is not held liable for damages it causes to Coarse Farm; it will obviously go for the option which gives maximum NPV i.e. it will build 2 tracks for NPV of $ 12 million. This is so because Coarse Farm has no control over Taggart’s actions in this case. In such a scenario, Coarse Farm will plant soya beans in number of fields which gives maximum NPV for two tracks of Taggart. This is given by 1 field and equal to $ 7 million. b. If Taggart is held fully liable for the damages, the NPVs of 3 cases for Taggart are as follows Table 5.1: Actual NPVs of Taggart No. of tracks Total NPV (in $ million) Damages (in $ million) Actual NPV (in $ million) 0 0 0 0 1 9 4 5 2 12 8 4 Since the actual NPV is maximum in case of 1 track, Taggart will go for this option. Now if there is 1 track, Coarse Farm gets maximum NPV of $11 million when soya beans are planted in 1 field. c. If the two firms merge, NPVs of each option can be evaluated as below: Table 5.2: Net NPVs of merged firms in various cases No. of tracks No. of fields Taggart NPV Coarse Farm NPV Net NPV 0 0 0 0 0 0 1 0 15 15 0 2 0 18 18 1 0 9 0-4 5 1 1 9 11 20 1 2 9 10 19 2 0 12 0-8 4 2 1 12 7 19 2 2 12 2 14 Except 0 fields, in other cases the loss due to damages has already been included in NPVs. The table implies that the merged firms will go for 1 track and 1 field since this option yields maximum NPV. d. The merger can have many implications. There may be a conflict in decision making between the higher management of the two companies. In the merged firm, there would be a problem in costing as well. The two businesses would have different cost structures, bill of material, margin levels and pricing strategies. Also, it would be difficult to evaluate the performances of both companies and their employees on similar criteria. Hence, lay-offs would become tricky. Also there may be a huge gap between the salaries of employees in two firms. Therefore, an adjustment would have to be made either in salary structure or designations. 6. I agree with the given statement. Capital budgeting plays a very important role in taking a firm ahead and making it profitable. For growing any business, new projects are needed whether in manufacturing or services industry. However, there is no use of taking projects unless they are profitable in a medium to long term. Capital budgeting gives managers the power to evaluate the profitability of a project. However, the most prominent use of capital budgeting is in comparison of two or more projects. In real life, a manger has a number of options before him which need to be evaluated for investment. Hence, Capital budgeting ensures that the firm’s money goes into the right direction. Read More