Capital Budgeting Problem Set
1. Rook, Inc., has the following mutually exclusive projects.
Year Project A Project B
0 –$15,000 –$17,000
1 10,100 12,500
2 5,700 4,300
3 2,100 5,500
a. Suppose the company’s payback period cutoff is two years. Which of these two projects
should be chosen?
b. Suppose the company uses the NPV rule to rank these two projects. Which project should
be chosen if the appropriate discount rate is 15 percent?
2. Compute the internal rate of return for the cash flows of the following two projects:
Year Project A Project B
0 –$7,800 –$4,560
1 4,050 2,140
2 3,620 2,280
3 2,890 1,920
3. Suppose the following two independent investment opportunities are available to a company. The
appropriate discount rate is 8.5 percent. Calculate the NPV and Benefit cost ratio and identify the
best project.
Year Project Alpha Project Beta
0 –$4,100 –$4,900
1 2,100 1,900
2 1,900 3,200
3 1,400 2,400
4. Consider the following cash flows on two mutually exclusive projects for the Bahamas Recreation
Corporation (BRC). Both projects require an annual return of 14 percent.
Year Deepwater Fishing New Submarine Ride
0 –$775,000 –$1,450,000
1 300,000 810,000
2 440,000 610,000
3 410,000 590,000
As a financial analyst for the company, you are asked the following questions:
a. If your decision rule is to accept the project with the greater IRR, which project should you
choose?
b. Because you are fully aware of the IRR rule’s scale problem, you calculate the incremental
IRR for the cash flows. Based on your computation, which project should you choose?
c. To be prudent, you compute the NPV for both projects. Which project should you choose?
Is it consistent with the incremental IRR rule?
Textbook mini case
5. Seth Bullock, the owner of Bullock Gold Mining, is evaluating a new gold mine in South
Dakota. Dan Dority, the company’s geologist, has just finished his analysis of the mine site.
He has estimated that the mine would be productive for eight years, after which the gold would
be completely mined. Dan has taken an estimate of the gold deposits to Alma Garrett, the
company’s financial officer. Alma has been asked by Seth to perform an analysis of the new
mine and present her recommendation on whether the company should open the new mine.
Alma has used the estimates provided by Dan to determine the revenues that could be expected
from the mine. She also has projected the expense of opening the mine and the annual operating
expenses. If the company opens the mine, it will cost $825 million today, and it will have a
cash outflow of $75 million nine years from today in costs associated with closing the mine
and reclaiming the area surrounding it. The expected cash flows each year from the mine are
shown in the following table. Bullock Mining has a 12 percent required return on all of its gold
mines.
Year Cash Flow
0 –$825,000,000
1 160,000,000
2 185,000,000
3 215,000,000
4 245,000,000
5 210,000,000
6 205,000,000
7 190,000,000
8 160,000,000
9 –75,000,000
Questions:
1. Construct a spreadsheet to calculate the payback period, internal rate of return, modified
internal rate of return, profitability index, and net present value of the proposed mine.
2. Based on your analysis, should the company open the mine?
Answers
Q1 Project A Payback - 1.859649, Project B Payback- 2.036364,
Project A NPV- ₹ -526.59, Project B NPV- ₹ 737.32
Q2 Project A IRR- 18%, Project B IRR- 19%
Q3 PI for Alpha- 1.133054, PI for Beta- 1.295589
Q4 IRR (Fishing)- 21%, IRR (Submarine)- 20%
Incremental IRR- 17%
NPV (Fishing)- ₹ 1,03,461.93
NPV (Submarine)- ₹ 1,28,134.70
Q5 Payback period- 4.10
IRR 16.15%
MIRR 13.66%
Profitability index- 1.15
NPV- $12,06,13,627.75