Prior to working this assignment, you should have already read the lecture notes, watched the instructor’s video, worked the practice problems and carefully reviewed the solutions. Further, you should be sure to read the Grading Rubric (attached to this assignment).
For each of the following questions, you will need to show your work. That means to show the equations used for items such as required return, average expected return, profitability index, etc. You will need to show your cash flow inputs (CF0 = ___, CF1 = ___ F01 = ___, etc.) for NPV (show once for NPV, then for IRR and PI, reference the NPV cash flows).
When you are using the financial calculator (or Excel), identify each of your inputs. Anyone looking at your work should be able to replicate your answer based on the backup info you provide. If in doubt of what constitutes “show your work”, look at Module 4 practice problem solutions.
Setup: Baker Corp. has several new projects that look attractive, but some are riskier than the firm’s past projects. Baker has received a major inflow of cash from a venture capital firm, in exchange for 25% of the firm’s closely held stock. The VC firm has asked Baker managers to “run the numbers” to examine both the market outlook and the expected returns on each of the projects they are considering. The cash infusion will not cover all the proposed projects; Baker and its new investors need to know which projects should be approved.
- Based on Baker’s earnings history over the past 10 years across a variety of projects, which have covered various states of the economy, the venture capital execs want Baker to estimate their overall returns. Given the following estimates of economy over the next several years, determine Baker’s expected rate of return. (6 pts)
Note, this type of development firm has much higher than normal returns under normal and boom conditions. The probability of each state of the economy reflects the current situation, not necessarily historic market conditions for the firm.
| State of the Economy | Current Probability of State of the Economy | Rate of Return if State Occurs |
| Boom | 25% | 19.0% |
| Normal | 55% | 9.0% |
| Recession | 20% | -15.0% |
Expected return for “average” company project (based on assumed economic probabilities) =
E( r ) = ( 25% * 19%) + ( 55%*9%) + ( 20%*-15%)
= (4.75%)+ ( 4.95%) + (-3% )
= 6.7% or 0.0670
- Historically, Baker projects have had an average beta of 1.4, which indicates the higher risk levels for the firm. Assuming the market risk premium (MRP) currently estimated to be 7% and the risk-free rate is 5.36%, what is the required return for an “average” Baker project using based on its average project beta? Show the average required return to 2 decimal places (x.xx%). (6 pts)
Expected return for “average” company project (based on current estimated MRP) =
R= Rf + ( beta * MRP)
Rf = 5.36%
Beta = 1.4
MRP= 7%
R= 5.36% + ( 1.4 * 7%)
R= 5.36% + ( 9.8% )
R = 15.16%
- The potential projects that Baker is considering have the following expected cash flows. Each project has its own unique risk and as such, the beta on each project is given. Using the data from #2 for the risk-free rate and market risk premium, what is the required percentage return for each of the projects? Show the required returns to 2 decimals, that is xx.xx%. You will use these rates when analyzing each project in the next part of the assignment, these are the required rates of return for Problems 4-7). (8 pts)
| #3 | Project A | Project B | Project C | Project D |
| Beta | 0.9 | 1.5 | 1.4 | 1.3 |
| Req. return (show work) |
NOTE: When a firm has projects that differ in risk (beta) than the “average” for the company, then the firm’s overall required return (from Problem 2) isn’t applicable. Each project needs to provide a return greater than or equal to its unique risk-adjusted required return. THE RATES CALCULATED FOR PROJECTS A – D IN #3 ARE THE REQUIRED RETURNS FOR EACH FOR THE FOLLOWING:
Use for Problems 4-7. For each project, calculate the NPV, IRR, profitability index (PI) and the payback period. For each capital budgeting decision tool, indicate if the project should be accepted or rejected, assuming that each project is independent of the others. Important Note: The venture capital folks, when considering payback period, have a firm maximum payback period of four years. This 4-year payback period has no impact on other capital budgeting analysis techniques, each is to be considered on its own. In other words, yes, all cash flows need to be considered for NPV, IRR, and PI.
Expected cash flows for the four potential projects that Baker is considering as shown below (each project ends when its cash flows end):
| Year | Project A | Project B | Project C | Project D |
| 0 | -$9,000,000 | -$8,000,000 | -$7,500,000 | -$6,000,000 |
| 1 | $2,000,000 | $3,000,000 | $2,000,000 | $1,000,000 |
| 2 | $2,000,000 | $2,000,000 | $2,000,000 | $2,000,000 |
| 3 | $2,000,000 | $2,000,000 | $1,500,000 | $2,000,000 |
| 4 | $2,000,000 | $1,500,000 | $1,500,000 | $1,000,000 |
| 5 | $2,000,000 | $1,200,000 | $2,500,000 | $1,000,000 |
| 6 | $2,000,000 | $1,000,000 | $2,500,000 | $1,000,000 |
| 7 | $2,000,000 | $750,000 | $1,000,000 | |
| 8 | $750,000 | $1,000,000 | ||
| 9 | $500,000 | $500,000 | ||
| 10 | $500,000 |
I have provided a suggested template for your final answers. Below the grid is where you should show all your required backup calculations (this means your cash flow register inputs, the interest rate, PI calculation and cumulative cash flows for payback). If you are working this in Excel, feel free to submit your Excel sheet, where the equations in the cells will provide the required backup. Be sure to clearly indicate the required rate of return for each project (you calculated each in Problem 3).
Remember that each capital budgeting method should be calculated and analyzed on a stand-alone basis.
| Year | Project A | Project B | Project C | Project D | ||
| Points | Req. Return (use 2 decimals xx.xx%) | |||||
| 6 | 4a | NPV (to nearest $1) | ||||
| 2 | 4b | NPV accept/reject | ||||
| 4 | 5a | IRR (xx.xx%) | ||||
| 2 | 5b | IRR accept/reject | ||||
| 4 | 6a | PI (show 2 decimals, x.xx) | ||||
| 2 | 6b | PI accept/reject | ||||
| 4 | 7a | Payback Period (x.x years) | ||||
| 2 | 7b | Payback accept/reject | ||||
If you need more room to show your work, just add space in this document or put at the end (but be sure your academic coach can easily find your work for each section).
THERE ARE DISCUSSION QUESTIONS ON THE NEXT PAGE (12 PTS)
- Discussion (No outside sources required all necessary information has been presented in Module 4 in Moodle)
- Using what you have learned in the lecture notes and having just analyzed each of the projects using the four key capital budgeting techniques, describe the reinvestment assumptions for each of the methods. (2 pts) Hint, the reinvestment rate assumptions have to do with how (if) the cash flows are discounted during analysis.
- NPV
- IRR
- Profitability Index (PI)
- Payback period
- For an independent project, which of the capital budgeting analysis techniques will always have the accept/reject decision, and why. Be precise in your explanation of “why” the techniques would agree. Hints: Keep it simple, don’t go down the “but what if…..” road. Independent projects – accepting one doesn’t mean you have to reject another one. Don’t assume financial constraints (you could theoretically fund all viable projects). Assume “normal” cash flows (only 1 sign change in other words, the outlay is considered negative and all future cash flows are positive), so that there is only a single IRR. (2 pts)
- How would a change in the required rate of return affect the project’s calculated internal rate of return (IRR)? Explain. Would the accept/reject decision change using the IRR analysis method? Explain. (2 pts)
- Think about changes that happen in a project once it has been accepted and moving forward. Here are 3 potential scenarios. For each, describe what you expect to happen to a project’s expected NPV, and WHY that is your expectation. (2 pts for each of the following).
As MBA students, just being able to calculate NPV isn’t sufficient. You should be able to consider what the effects of various market or project changes on the project’s viability.
LOOK AT EACH SITUATION INDIVIDUALLY AND ASSUME THAT THERE ARE NO OTHER CHANGES FOR THE FIRM.
- Your firm has a project with lower risk than your firm’s “regular” project. The project has been tentatively accepted for development, assuming a required rate of return of 13%. That required rate of return was estimated one year ago, before the FED began its interest rate hikes. The risk free rate has increased by 2.5% from that used in the original projection.
- Due to a (lucky) miscalculation by the marketing folks, demand for your project’s products has increased in the early years of the project, but that “stole” sales from future years. The same total inflows were achieved, but the timing was more front-loaded than anticipated.
- Once construction began on the project, a rare black-footed ferret was found nearby. Environmental groups have demanded that the project halt operations for 9 months while the ferrets are found and relocated. Once the ferrets were moved, operations continued as originally planned, but with all cash flows shifted out by 12 months.
- Your firm is looking at three mutually exclusive projects. Describe how you would decide which project(s) to accept, be very clear on which capital budgeting techniques you would use and how you make your decision. (2 pts) The lecture notes cover this one, review as needed.
