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files (2)ApplicationofCapitalBudgetingAnalysisTechniques.docx
PA2springAP12025studentversion.docx
ApplicationofCapitalBudgetingAnalysisTechniques.docx
Application of Capital Budgeting Analysis Techniques
Download the attached MS Word file. I suggest you make a copy of the file and use a file name that has your Last Name and PA2 or similar. It is each student's responsibility to verify that all files have been submitted successfully AND that all files are included. There are 5 POINT penalties for incomplete or incorrect submissions. You will have a max of 24 hours after you are notified of the incorrect file to get back to your academic coach and update your submission. Questions on the assignment? Email your academic coach or instructor. Each term a couple of students submit the original file instead of the one with their solutions. They have lost points for late submissions because the correct files aren't submitted on time. Double-check that you are submitting the correct file.
"A reminder as you prepare to submit your second Practical Application to highlight only your final answer for 1-3. Please submit the answers for 4-7 in the same table format if you are not using the worksheet. There is no need to highlight the chart or your written answers for the remainder to the assignment."
PA2springAP12025studentversion.docx
MBA702 Spring 2025 AP1 PRACTICAL APPLICATION 2
Prior to attempting this assignment, you should have already read the lecture notes, watched the instructor’s video, worked the practice problems, and carefully reviewed the solutions. Further, it would be best if you were to read the Grading Rubric (attached to this assignment).
You will need to show your work for each of the questions. That means to show the equations used for items such as required return, average expected return, profitability index, etc. You must show your cash flow inputs (CF0 = ___, CF1 = ___ F01 = ___, etc.) for NPV (show once for NPV, then for IRR and PI, reference the NPV cash flows).
When you are using the financial calculator (or Excel), identify each of your inputs. Anyone looking at your work should be able to replicate your answer based on the backup info you provide. If in doubt of what constitutes “show your work”, look at Module 4 practice problem solutions.
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.
i. 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 |
15% |
15.00% |
|
Normal |
55% |
9.00% |
|
Recession |
30% |
-13.00% |
Expected return for “average” company project (based on assumed economic probabilities) =
ii. Historically, Baker projects have had an average beta of 1.20, indicating higher risk levels for the firm. Assuming the market risk premium (MRP) is currently estimated to be 7.5% and the risk-free rate is 3.9%, what is the required return for a Baker project 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) =
iii. 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 4-7). (8 pts)
|
#3 |
Project A |
Project B |
Project C |
Project D |
|
Beta |
1.1 |
1.2 |
1.3 |
0.9 |
|
Req. return (show work) |
|
|
|
|
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 |
-$8,000,000 |
-$5,750,000 |
-$3,500,000 |
|
1 |
$1,000,000 |
$1,250,000 |
$1,000,000 |
$750,000 |
|
2 |
$1,000,000 |
$1,250,000 |
$1,000,000 |
$750,000 |
|
3 |
$1,000,000 |
$1,250,000 |
$1,500,000 |
$750,000 |
|
4 |
$1,000,000 |
$1,250,000 |
$2,500,000 |
$750,000 |
|
5 |
$200,000 |
$1,250,000 |
$2,500,000 |
$500,000 |
|
6 |
$1,000,000 |
$1,250,000 |
|
$500,000 |
|
7 |
$800,000 |
$1,250,000 |
|
$500,000 |
|
8 |
$800,000 |
$1,250,000 |
|
$500,000 |
|
9 |
|
$1,250,000 |
|
$500,000 |
|
10 |
|
$1,250,000 |
|
$500,000 |
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 on 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 |
|
Points |
|
Req. Return (use 2 decimals xx.xx%) |
|
|
|
|
|
6 |
4a |
NPV (to nearest $1) |
|
|
|
|
|
2 |
4b |
NPV accept/reject |
|
|
|
|
|
4 |
5a |
IRR (xx.xx%) |
|
|
|
|
|
2 |
5b |
IRR accept/reject |
|
|
|
|
|
4 |
6a |
PI (show 2 decimals, x.xx) |
|
|
|
|
|
2 |
6b |
PI accept/reject |
|
|
|
|
|
4 |
7a |
Payback Period (x.x years) |
|
|
|
|
|
2 |
7b |
Payback accept/reject |
|
|
|
|
|
|
|
|
If you need more room to show your work, just add space in this document or put at the end (but be sure your academic coach can easily find your work for each section).
THERE ARE DISCUSSION QUESTIONS ON THE NEXT PAGE (12 PTS)
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. Payback Period
ii. Profitability Index (PI)
iii. NPV
iv. IRR
c) How would an increase in the required rate of return affect the project’s calculated NPV? ii) How would the increase in the required rate of return impact the project’s internal rate of return (IRR)? Assume no change to the timing or amount of cash flows. Explain each and be specific as to Why (or if there is an impact) and how would the higher required rate change the NPV and the IRR (2 answers here) and what is the possible impact on the accept/reject decision for the project under each of the two analysis methods (another 2 answers). (2 pts)
9. Think about changes in a project once it has been accepted and moving forward. Here are 3 potential scenarios. For each, assume everything else stays the same and 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). Recall the 3 important factors for value: riskiness of cash flows (think required rate of return), timing of cash flows, and amount of cash flows.
As MBA students, just being able to calculate NPV isn’t sufficient. You should be able to consider 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.
a) Labor shortages and supply delays have hit your company across most sectors, including a new hotel that is under construction. Instead of the hotel opening in September of 2023, it is now anticipated that the hotel won’t be completed until mid-2025. These changes are anticipated to both increase construction costs as well as delay projected revenues on the project. Note: be sure to discuss each of these issues and whether they will offset or multiply the effect on NPV.
b) Newly available technology has reduced operating costs for a project in year 2 of a project that still has 8 years of viable life. No other changes in the project have occurred.
c) Two years ago, when the original cash flow projections were prepared for one of your company’s projects it was assumed that at the project’s end (another 6 years from now), the heavy equipment would be sold for $4mm to a competitor. Due to much heavier wear on the equipment, it is now assumed that the equipment will be worth less than $1mm at the project’s end.
10. 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.
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