Cash Flows (in thousands of USD) Year 0 1 2 3 4 5 6 7 Project 1 -100 10 20 0 0 1
ID: 2774229 • Letter: C
Question
Cash Flows (in thousands of USD)
Year
0
1
2
3
4
5
6
7
Project 1
-100
10
20
0
0
110
0
0
Project 2
-100
0
0
0
40
50
80
10
Project 3
-250
0
15
20
30
40
150
110
Project 4
-500
150
150
-100
50
100
150
200
Project 5
-400
100
100
-100
200
200
-80
130
In the above table, five projects were proposed from different departments of the firm trying to compete for the total $1,000,000 capital budget for next year. The CFO made it clear at the meeting that any project with zero or negative NPV should not be funded. Given it is a pharmaceutical firm, the CFO and the key managers are used to concepts of investing in the long-term projects and/or relatively risky projects, and/or projects with volatile cash flows over time. In addition, most of the members on the committee are cautiously optimistic about the future outlook of the economy. Around the time of the meetings, there were rumors that the Federal Reserve Bank is considering increasing the prime interest rates.
1) Assume again that the discount rate is 7%. Suppose that the firm suffers a drop in profits due to a foreign exchange rate change, and as a result, the total capital budget is reduced from one million dollar to $600,000. What’s your capital budgeting decision now? Please explain why or why not you have changed your decisions.
Cash Flows (in thousands of USD)
Year
0
1
2
3
4
5
6
7
Project 1
-100
10
20
0
0
110
0
0
Project 2
-100
0
0
0
40
50
80
10
Project 3
-250
0
15
20
30
40
150
110
Project 4
-500
150
150
-100
50
100
150
200
Project 5
-400
100
100
-100
200
200
-80
130
Explanation / Answer
Project 3 has a negative NPV. So, we have only 4 project left to consider. Now, we have a capital budget of $1,000, 000 for the next year.
We have 4 projects to choose from
Project 1 with capital invetsment of $100,000
Project 2 with capital invetsment of $100,000
Project 4 with capital invetsment of $500,000
Project 5 with capital invetsment of $400,000
Thus, if we want to do all the projects, we need a budget of $1,100,000 which is not possible since we have a budget of only $1,000,000. So, we eliminate project 1 which has the lowest NPV and choose projects 2, 4 and 5 which fit in the capital budget of $1,000,000 (100,000 + 400,000 + 500,000).
Combined NPV of Prjects 2, 4 and 5 = 25.7 + 23.52 + 22 = $71.22
Now the capital budget reduces to $600,000 from $1,000,000.So, we will have to review our decisions again.
Now, we have to choose projects in such a manner so that the combined NPV is the highest and the capital invetsment does not exceed $600,000. So, the decision that we had taken earlier of Projects 2, 4 and 5 has to be changed since the capital investment exceeds $600,000.
First of all we choose project 2 which has the highest NPV and a low investment. Next out of projects 4 and 5, although project 4 has a higher NPV, we choose project 5 since it requires a lower investment and we can fit project 1 also in our budget. If project 4 is taken, no other project can be taken up.
So combined NPV of projects 1,2 and 5 = 5.24 + 25.7 + 22 = $52.94 (investment = 100+100+400 = 600)
Combined NPV of projects 2 and 4 = 25.7 + 23.52 = $49.22 (Investment = 100 + 500 = 600)
Both the scenarios have a capital investment of $600,000 which fit in our budget.
Thus, we decide to take up Project 1, Project 2 and Project 5 since the NPV of this combination is the highest within the given capital budget of $600,000. The earlier decision of projects 2, 4 and 5 has to be changed since the capital investment exceeds $600,000.
Cash Flows (in thousands of USD) Year 0 1 2 3 4 5 6 7 NPV Project 1 -100 10 20 0 0 110 0 0 $5.24 Project 2 -100 0 0 0 40 50 80 10 $25.70 Project 3 -250 0 15 20 30 40 150 110 ($0.71) Project 4 -500 150 150 -100 50 100 150 200 $23.52 Project 5 -400 100 100 -100 200 200 -80 130 $22.00Related Questions
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