Question

2Assume that you are a new analyst hired to evaluate the capital budgeting projects of the company which is considering investing in two CPEC projects, “Expansion Zone North” and “Expansion Zone East”. The initial cost of each project is Rs. 10,000. Company discount all projects based on WACC. Further, all the projects are equally risky projects and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at an interest rate of rd 10% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. The dividend for next period is $2.0, its expected that they will grow at the constant growth rate of 8%, and the company’s common stock sells for $20. The tax rate is 50%.

2Assume that you are a new analyst hired to evaluate the capital budgeting projects of the company which is considering investing in two CPEC projects, “Expansion Zone North” and “Expansion Zone East”. The initial cost of each project is Rs. 10,000. Company discount all projects based on WACC. Further, all the projects are equally risky projects and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at an interest rate of rd 10% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. The dividend for next period is $2.0, its expected that they will grow at the constant growth rate of 8%, and the company’s common stock sells for $20. The tax rate is 50%.

The cash flows of both the projects are given in table below:

Time	Expansion Zone North Cashflows (amount in Rs.)	Expansion Zone East Cashflows (amount in Rs.)
0	10,000	10,000
1	6,500	3,500
2	3,000	3,500
3	3,000	3,500
4	1,000	3,500

Carefully analyze the above table and answer the following questions in detail.

1. Calculate the weighted average cost of capital for this firm?
2. Compute each project’s IRR, NPV, payback, MIRR, and discounted payback.
3. Which project(s) should be accepted if they are mutually exclusive? Explain
4. Which project(s) should be accepted if they are independent? Explain

Answer 1

Q1) Cost of equity= dividend / price + growth rate

= 2 / 20 + 0.08

= 0.10 + 0.08

= 0.18 or 18%

After tax cost of debt = debt (1 - tax rate)

= 10% (1 - 0.50)

= 10% (0.50)

= 5%

WACC= weight of debt × after tax cost of debt + weight of equity × cost of equity

= 0.5 × 5% + 0.5 × 18%

= 2.5% + 9%

= 11.5%

Q2) Using financial calculator to calculate the NPV of Expansion Zone North

Inputs: C0= -10,000

C1= 6,500. Frequency=1

C2= 3,000. Frequency= 2

C3= 1,000 Frequency= 1

I = 11.5%

Npv= compute

We get, NPV of Expansion Zone North as $1,053.87

Using financial calculator to calculate the NPV of Expansion Zone East

Inputs: C0= -10,000

C1= 3,500. Frequency= 4

I = 11.5%

Npv= compute

We get, NPV of Expansion Zone East as $743.65

IRR of the projects

Using financial calculator to calculate the IRR of Expansion Zone North

Inputs: C0= -10,000

C1= 6,500. Frequency=1

C2= 3,000. Frequency= 2

C3= 1,000. Frequency= 1

IRR= compute

We get, IRR of the Expansion Zone North as 18.032%

Using financial calculator to calculate the IRR of Expansion Zone East

Inputs: C0= -10,000

C1= 3,500. Frequency=4

IRR= compute

We get, IRR of the Expansion Zone East as 14.963%

Payback Period

Expansion Zone North

Years	Cash flow	Cummulative Cashflow
0	- 10,000	-10,000
1	6,500	-3,500
2	3,000	-500
3	3,000	2,500
4	1,000	3,500

Payback Period = Year before Payback occurs + Cummulative cashflow before recovery/ cash flow after recovery

= 2 + 500 / 3,000

= 2 + 0.1667

= 2.17 years

Expansion Zone East

Years	Cash flow	Cummulative Cashflow
0	-10,000	-10,000
1	3,500	-6,500
2	3,500	-3,000
3	3,500	500
4	3,500	4,000

Payback Period = Year before Payback occurs + Cummulative cashflow before recovery/ cash flow after recovery

= 2 + 3,000 / 3,500

= 2 + 0.86

= 2.86 years

Discounted Payback Period

Expansion Zone North

Years	Cash flow	Present value of cashflow	Cummulative Cashflow
0	(10,000)	- 10,000	-10,000
1	6,500	5,829.6	-4,170.4
2	3,000	2,413.08	-1,757.32
3	3,000	2,164.2	406.87
4	1,000	646.99	1,053.87

Discounted Payback period= Year before discounted Payback occurs + Cummulative cashflow before recovery/ cash flow after recovery

= 2 + 1,757.32 / 2,164.2

= 2 + 0.81

= 2.81 years

Expansion Zone East

Years	Cash flow	Present value of cashflow	Cummulative Cashflow
0	-10,000	- 10,000	-10,000
1	3,500	3,139.01	-6,860.99
2	3,500	2,815.26	-4,045.73
3	3,500	2,524.9	-1,520.83
4	3,500	2,264.48	743.65

Discounted Payback period= Year before discounted Payback occurs + Cummulative cashflow before recovery/ cash flow after recovery

= 3 + 1,520.83 / 2,264.48

= 3 + 0.67

= 3.67 years

Q3) If the projects are mutually exclusive then we should choose Expansion Zone North, because it has higher NPV.

Q4) If the projects are independent then we can choose both the Projects because both of them have positive NPV.