Introduction to Capital Budgeting Exercises

Exercises

Question 1
What are the four capital budgeting decision criteria?

Question 2
Identify 4 flaws of the payback period? Given these flaws, why should you know the payback period method?

Question 3
With independent projects that do not suffer from the crossover (multiple IRR) problem, will the IRR and NPV always give the same accept reject decision? Explain.

Question 4
What are 3 potential problems with the IRR? Given these flaws, why should you know the IRR method?

Question 5
How can we account for risk under each of the three methods (PP, IRR, NPV)?

Question 6
Consider a situation where a firm carefully performs capital budgeting analysis and selects a project with a high, positive NPV. Three years later, the project is terminated early and the company has lost significant money on the project. Does this mean that their capital budgeting process is flawed? Explain.

Problem 1
Calculate the PP, NPV, and IRR of the following projects (assuming a 14% required return and critical acceptance level <T> of 3 years)

Cash Flow     Project A     Project B     Project C     Project D
CF₀     -$1,000,000     -$1,000,000     -$500,000     -$500,000
CF₁     400,000     150,000     200,000     75,000
CF₂     400,000     100,000     250,000     50,000
CF₃     225,000     550,000     150,000     225,000
CF₄     200,000     775,000     100,000     387,500

Which project(s) should we accept if they are independent? Mutually Exclusive?

Problem 2
In the problem above, identify a pair of projects that could suffer from the size problem, but not a reinvestment rate problem. Next, identify a pair of projects that could suffer from the reinvestment rate problem, but not the size problem.

Source: Kevin Bracker, Fang Lin, Jennifer Pursley, https://businessfinanceessentials.pressbooks.com/chapter/chapter-8-introduction-to-capital-budgeting/
This work is licensed under a Creative Commons Attribution-NonCommercial 4.0 License.