Valuing Capital Investment
Mulbah Corporation has $40 million that it can invest in any or all of the four capital investment projects, which have cash flows as shown below.
|
|
Year of Cash Flow |
| Project |
Types of Cash Flow |
Year 0 |
Year 1 |
Year 2 |
Year 3 |
| A |
Investment
Revenue
Operating expenses
|
($10,000)
|
$21,000
$11,00
|
|
|
| B |
Investment
Revenue
Operating expenses
|
($10,000)
|
$15,000
$5,833
|
$17,000
$7,833
|
|
| C |
Investment
Revenue
Operating expenses
|
($10,000)
|
$10,000
$5,555
|
$10,000
$5,555
|
$30,000
$15,555
|
| D |
Investment
Revenue
Operating expenses
|
($10,000)
|
$30,000
$15,555
|
$10,000
$5,555
|
$5,000
$2,222
|
| All revenues and operating expenses can be considered cash items. |
Each of these projects is considered to be of equivalent risk. The investment will be depreciated to zero on a straight-line basis for tax purposes.
Mulbah's corporate tax rate on taxable income is 40%. None of the projects will have any salvage value at the end of their respective lives. For purposes of analysis, it should be assumed that all cash flows occur at the end of the year in question.
1. Rank Mulbah's corporation four projects according to the following four commonly used capital budgeting criteria:
a) Payback period.
b) Accounting return on investment.
c) Internal rate of return.
d) Net present value, assuming alternately a 10% discount rate and a 35% discount rate.
2. Why do the ranking differ? What does each technique measure and what assumptions does it make?
3. If the projects are independent of each other, which should be accepted? If they are mutually exclusive (i.e., one and only one can be accepted), which one is best?