Assignment II

1. What is capital budgeting? What is the difference between

independent and mutually exclusive projects?

Capital budgeting involves analyzing potential investments, such

as purchasing new equipment, expanding operations, or launching
new products, to determine their profitability and impact on the
company's financial position. The goal of capital budgeting is to
allocate resources efficiently to maximize shareholder value.

The difference between independent and mutually exclusive

projects is that independent projects do not compete, whereas
mutually exclusive projects do. For independent projects, if they all
meet financial criteria, the company can undertake multiple
projects simultaneously. However, for mutually exclusive projects,
the company can select only one, meaning it must choose the best
option.

2. What are the rules of project evaluation for independent and

mutually exclusive projects according to NPV and IRR?

NPV measures the present value of cash inflows minus the present
value of cash outflows. It is a direct indicator of how much value a
project adds to a company.
IRR is the discount rate that makes the NPV of a project equal to
zero. It represents the expected annual return of the project.
Independent project: If the project NPV larger than 0 or IRR larger
than required rate of return, project can be accepted. We can
choose multiple projects at one time.
Mutually Exclusive Project: We can choose only one project with
highest positive NPV or highest IRR.

3. Conflicts between two mutually exclusive projects occasionally

occur, where the NPV method ranks one project higher, but the
IRR method ranks the other one first. In theory, such conflicts
 should be resolved in favor of the project with the higher positive
NPV. Explain.

For mutually exclusive projects, conflicts between NPV and IRR

can arise due to factors such as scale differences, cash flow timing
differences, and non-conventional cash flows. When such conflicts
occur, NPV should be prioritized. This is because NPV directly
measures the value a project adds to a firm, making it a more
reliable metric. Choosing the project with the higher NPV ensures
the maximization of the firm’s value and shareholders’ wealth.
Additionally, NPV assumes a reinvestment rate equal to the
Weighted Average Cost of Capital (WACC), whereas IRR assumes
reinvestment at the IRR itself.

4. What are callable and convertible bonds. Explain if these bonds

will have higher or lower rate of required returns relative to regular
bonds.

A callable bond is a type of bond that allows the issuer to redeem

or buy back the bond before its maturity date at a predetermined
call price. Issuers typically call bonds when interest rates decline,
enabling them to refinance at a lower cost. A convertible bond is a
bond that gives the holder the right to convert it into a
predetermined number of shares of the issuing company’s stock.
Investors can convert their bonds when the stock price rises
significantly, benefiting from potential capital appreciation.
For callable bonds, because investors must undertake call risk and
reinvestment risk, callable bonds usually offer higher coupon rates
than non-callable regular bonds. For convertible bonds, investors
are willing to accept lower yields because they can gain extra value
by converting their bonds into stock when the stock price rises.

5. Explain bond ratings. What do the ratings represent for the

investors.
Bond ratings are credit ratings assigned to bonds by rating
agencies, such as Moody’s and Standard & Poor’s (S&P), to assess
the creditworthiness of the issuer and the likelihood that the bond’s
principal and interest payments will be made on time. These ratings
help investors understand each bond’s risk level, enabling them to
make informed investment decisions.
 Higher-rated bonds have lower risk, meaning issuers have a higher
probability of making timely interest and principal payments.
Lower-rated bonds typically offer higher returns to compensate for
the increased risk of default.

6. Explain cannibalization. What should be the impact of

cannibalization on project’s future cash flows?
When a company releases a new product that reduces the sales,
revenue, or market share of an existing product within the same
company, leading to internal product competition, this
phenomenon is known as cannibalization.
When cannibalization occurs, it may reduce incremental cash flows
because part of the new product’s sales comes from replacing the
old product rather than expanding overall market demand. As a
result, incremental cash flows will be lower than expected.
However, if the new product achieves economies of scale, it can
reduce overall production costs and improve long-term
profitability.
In the long run, cannibalization is a necessary strategic move. Even
if your company does not launch a new product, competitors will,
meaning cannibalization may not occur internally, but your
company will lose market share to competitors.
Problems

1. Rogoff Co.'s 15-year bonds have an annual coupon rate of 9.5%.

Each bond has face value of $1,000 and makes semiannual interest
payments. If you require an 11.0% nominal yield to maturity on
this investment, what is the maximum price you should be willing
to pay for the bond?

FV=1,000
Annual coupon rate= 9.5%
Yield to maturity=11.0%
Years=15
Semiannual coupon payment= (9.5%/2)*1000=47.50
Semiannual Yield= 11/2=5.5

N=30 (15*2)
I/Y= 5.5 (11/2)
PMT=47.5
 FV=1,000
30N ->5.5 I/Y -> 47.5 PMT -> 1000 FV -> CPT PV

Ans: 891.00

2. Jerome Corporation's bonds have 15 years to maturity, an 8.75%

coupon paid semiannually, and a $1,000 par value. The bond has a
6.50% nominal yield to maturity, but it can be called in 6 years at a
price of $1,050. What is the bond's nominal yield to call?

Year: 15 (can be called in 6 years ->6*2=12)

coupon paid: 8.75%
Par Value= 1000
YTM=6.5%
call price: 1,050
PMT=(8.75%/2)*1000=43.75

Step 1: calculate PV or Current Price of the Bond

N=30(15*2)
I/Y=3.25 (6.5%/2)
PMT=43.75
FV=1,000
CPT PV=1,213.55
Step 2: Calculate YTC
N=12 (6*2)
PMT=43.75
FV=1050
PV=-1213.55
CPT I/Y= 2.64%
YTC=2.64%*2=5.28%

Ans: 5.28%

3. Company’s preferred stock carries a constant perpetual annual

dividend of $2 per share. What is the current price of the preferred
stock if the investors require 5% annual rate of return?

Current price of the preferred stock= annual dividend per share/

Required rate of return=2/0.05=40

Ans:40
4. Garner Inc. is considering a project that has the following cash
flow data. What is the project's payback?
Year 0 1 2 3
Cash
−$350 $200 $200 $200
flows
Year 0: -350
Year 1: -350+200=-150
Year 2: -150+200=50
Year 3: 50+200=250

150/200=0.75 ( it means year 2 spend 0.75 year to get 0)

1+0.75=1.75

Ans:1.75 years

5. Modern Refurbishing Inc. is considering a project that has the

following cash flow data. What is the project's IRR?
Year 0 1 2 3 4
Cash
−$850 $300 $290 $280 $270
flows

CF -> CF0=-850 -> C01=300 -> F01=1 -> C02=290 -> F02=1 ->
C03=280 -> F03=1-> C04=270 -> F04=1 -> IRR CPT
IRR=13.13

Ans:13.13

6. Reed Enterprises is considering a project that has the following

cash flow and cost of capital (r) data. What is the project's NPV?
r: 10.00%
Year 0 1 2 3
 Cash
−$1,050 $450 $460 $470
flows

CF0=-1050 -> C01=450 -> F01=1 -> C02=460 -> F02=1 ->
C03=470 -> F03=1 ->NPV I=10 -> CPT

NPV=92.37

Ans:92.37

7. Watts Co. is considering a project that has the following cash flow
and cost of capital (r) data. What is the project's MIRR?
r= 10.00%
Year 0 1 2 3 4
Cash
−$850 $300 $320 $340 $360
flows
C01=300 -> F01=1 -> C02=320 -> F02=1 -> C03=340 -> F03=1 -
> C04=360 -> F04=1 -> NPV I=10 -> CPT
NPV=1038.52

PV=1038.52, I?Y=10, N=4 Compte FV=1520.50

N=4
PV=-850
FV=1520.5
I/Y=? (MIRR)
4N -> -850 PV -> 1520.5 FV -> CPT I/Y

I/Y (MIRR)=15.65

Ans:15.65

8. The Brownstone’s Corporation’s bonds have 5 years remaining to

maturity. Interest rate is paid annually, the bonds have a $1000 par
value, and the coupon rate is 9%. What is the yield to maturity if
the current market price is $829. Would you pay $829 for one these
bonds if market interest is 12%?

N=5
PV=-829
 PMT=90 (9%*1000)
FV=1,000

5N -> -829 PV -> 90 PMT -> 1000 FV -> CPT I/Y

I/Y=13.98
13.98% higher than market interest 12%, So it is worth buying.

Ans: Yes

9. Project S has a cost of $10000 and expected to produce cash flows

of $3000 per year for 5 years. Project L costs $25000 and is
expected to produce cash flows of $7400 per year for 5 years.
Calculate two Projects’ NPVs, IRRs and MIRRs. Assuming a cost
of capital of 12%. Which project would be selected assuming they
are mutually exclusive, using each ranking method?

Project S Project L
Year 0 10,000 25,000
Cash flow 3,000 7,400
years 5 5
12% 12%

Project S NPV:
CF -> CF0=-10,000 -> C01=3,000 -> F01=5 -> NPV I=12 -> CPT
Project S NPV=814.33

Project L NPV:
CF -> CF0=-25,000 -> C01=7,400 -> F01=5 -> NPV I=12 -> CPT
Project S NPV=1675.34

Project S IRR:
CF -> CF0=-10,000 -> C01=3,000 -> F01=5 -> IRR CPT
Project S IRR=15.24

Project L IRR:
CF -> CF0=-25,000 -> C01=7,400 -> F01=5 -> IRR CPT
Project S IRR=14.67

Project S MIRR
Compute NPV without CF0 = 10,814.33.
PV=10,814.33, I/Y=12, N=5, Compute FV=19,058.54. This is
Terminal Value

Project S MIRR:
FV=19,058.54, PV=10,000, N=5, Compute I/Y =13.77

Project L MIRR:
Compute NPV without CF0 =26,675.34
PV= 26,675.34, N=5. I/Y=12 Compute FV =47011.06
PV=25,000, FV=47011.06, N+5, Compute I/Y=13.46

Ans: Project L