Question 6: Charles Wagon (his friends call him Chuck), is a first round draft c

Question

Question 6: Charles Wagon (his friends call him Chuck), is a first round draft choice of the Cleveland Browns. You are Chuck’s agent. The Browns are proposing two deals: - Offer 1: $4 million a year for the next 5 years. - Offer 2: $8 million now and $2 million a year for 5 years. The interest rate is 10%. Which is the better deal? Show the numbers. (Hint: Bring everything back to today’s dollars.) Question 7: Briefly describe, in your own words, what Capital Budgeting is. Question 8: Briefly describe, in your own words, the disadvantages of the Payback Method in Capital Budgeting. Question 9: What is the rule regarding Net Present Value? When should a project be accepted using this rule? Question 10: A Broadway show will cost $17,000,000 to put on and will require that the entire investment be spent up front. The show is then expected to bring in $5,000,000 a year for four years. The investors estimate that they can earn 7% a year on their money if it is not invested in this show. Calculate the Net Present Value of investing in this show and state whether or note the investors should or should not make this investment and why.

Explanation / Answer

7. Capital Budgeting: It is the process of figuring out which projects are financially worth an investment.

Example: Lets assume company XYZ is decising whether to purchase a piece of factory equipment for $300,000. The equipment would only last three years, but it is expected to generate $150,000 of additional profit per year during those years. And company XYZ also thinks that it can sell the erquipment for scrap afterward for about $10,000. Using an internal rate of return (IRR) calculation company XYZ can be determined whether the purchase is a better use of cash than some of the company XYZ's other investment options, which in return about 10%.

8. Disadvantages of payback method in capital budgeting:

a) Payback ignores the true value of money

Ex: Two projects are viewed equally attractive if they have some payback regardless of when the payback

regardless of when the payback occurs.

b) Payback also ignores the cash flows beyond the payback period, ignoring the profitability of the project.

c) To calculate a more exact payback period

Payback period= Amount to be invested/Estimated annual net cash flow

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