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Capital Budgeting

fmccrayfmccray OklahomaPosts: 20 Associate

Hi, I have two questions on the bolded parts. would anyone happen to know why it is not C01=100 , F01=5. the other part is that i would have put C02=50. i would hate to loose on this question as it is relatively easy. Thank you so much for you help.

Question 1:

C01 = 100, F01 = 4, C02 = 150, F02 = 1

Digital Design Corporation is considering an investment of £400 million with expected after-tax cash inflows of £100 million per year for five years and an additional after-tax salvage value of £50 million in Year 5. The required rate of return is 7.5 percent. What is the investment’s PI? 


A0.8.B1.2.C1.1.

Explanation:

C is correct. The Profitability Index scales the NPV according to the size of the initial investment. It is calculated as the present value of a project’s future cash flows divided by the initial investment:

Profitability Index PI = PV of future cash flows/ initial investment = 1 + NPV/initial investment

Using the calculator: CF0 = - 400, C01 = 100, F01 = 4, C02 = 150, F02 = 1, I = 7.5, CPT NPV. NPV = 39.41.

PI = 1 + (39.41/400) = 1.098 = 1.1 approx.


Question 2:

The questions did not say if $60 in year 1 is negative. How can i tell from the question? CF2 = -60.

A project investment of $100 generates after-tax cash flows of $50 in Year 1, $60 in Year 2, $120 in Year 3 and $150 in Year 4. The required rate of return is 15 percent. The net present value is closest to:

A$153.51.B$158.33.C$168.52.

Your answer was Wrong.

Explanation:

A is correct. Net present value is the present value of the future after-tax cash flows minus the investment outlay.

NPV = -100 + (50/1.15) + (60/(1.15)^2) + (120/(1.15)^3) + (150/(1.15)^4) = 153.51.

Using a financial calculator, enter the cash flows.

CF0 = - 100, CF1 = 50, CF2 = -60, CF3 = 120, CF4 = 150, I = 15, CPT NPV. NPV = 153.51.

Comments

  • Hey @fmccray:

    For question 1, there is just a slight error in your understanding here. For the last final year where t=5 (5th year), not only there is £100m after tax cash inflow, there is also the £50m after tax salvage value. The salvage value ALSO happens in the final year, i.e. t=5, NOT t=6.

    If you put C01=100 , F01=5, and C02=50, you are assuming that the £50m salvage value is received in year 6, which is incorrect.

    In year 5, the total cash inflow is £150m (£100m + £50m salvage value), hence C01 = 100, F01 = 4, C02 = 150, F02 = 1 is correct.

    Does this make sense?


    For question 2, the minus sign on CF2 is incorrect and a typo on the publisher's part. If you compute this without minus sign on 60 you should get 153.51 as I did.

    CF0 = - 100, CF1 = 50, CF2 = 60, CF3 = 120, CF4 = 150, I = 15, CPT NPV. NPV = 153.51.


    Hope these helps!

  • fmccrayfmccray OklahomaPosts: 20 Associate

    Thank you so much Sophie. yes, you are right. i was not thinking about the question correctly.

    Sophie
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