A listed company has a proposed investment project where the expected cash flows are given in the table below. Market research into a feasibility study for the project was conducted at a cost of $5,000. The risk-free rate of return is given as 2% per annum. The yearly return for the Australian share market is given as 12%. Suppose the company has a beta value of 0.8.
Year 0 Project cash flow $(20,000)
Year 1 Project cash flow $(10,000)
Year 2 Project cash flow $(20,000)
Year 3 Project cash flow $(10,000)
Year 4 Project cash flow $(40,000)
Year 5 Project cash flow $(30,000)
(a) Determine the project’s discount rate.
(b) Explain what is meant by sunk costs in capital budgeting. State the amount of any sunk costs for the project.
(c) What type of risk does the beta value measure? Explain what is meant by this particular type of risk.
(d) If the maximum acceptable payback period for the project is 3 years, would the project be accepted? What are the disadvantages of the payback period method in making investment decisions?
(e) Explain the difference between the discounted payback period method and the payback period method. Would the project be accepted if the discounted payback period is used instead of the payback period?
(f) Explain whether the project would be accepted using the net present value (NPV) acceptance criterion. Explain why the NPV method is considered to be the best method in capital budgeting.
(g) Explain whether the project would be accepted using the profitability index (PI) acceptance criterion.
(h) Explain whether the project would be accepted using the internal rate of return (IRR) acceptance criterion. Explain why the IRR method is widely used in capital budgeting.