Capital Budgeting is part of company's investment process. Capital Budgeting techniques are essential tools for corporate managers as well as external analysts.
Problem 1 examines the relation between NPV and stock prices. A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of its shareholders. Thus, the NPV criterion is the criterion most directly related to stock prices.
Problem 2 examines some of the drawbacks of the payback period.
1. ABC Corporation is investing $500 million in production facilities. The present value of all future cash flows is estimated to be $700 million. Assume that all cash flows are after- tax. ABC has 180 million outstanding shares with a current market price of $25 per share. Assume that this investment is new information, and is independent of other expectations about the company.
a. What is the NPV of the new project?
b. What is the market value of the company without the new project?
c. What should be the new effect of the project on the value of the company?
d. What should be the new effect of the project on the stock price?
Hint: Market value of the company is same as market capitalization and is calculated as: Market capitalization = shares outstanding * market price
2. The cash flows, payback period, and NPV for different projects are given below. The required rate of return is 10 percent.
|
Year
|
Project A
|
Project B
|
|
0
|
$(1,000.00)
|
$(1,000.00)
|
|
1
|
$500.00
|
$500.00
|
|
2
|
$500.00
|
$500.00
|
|
3
|
$500.00
|
$10,000.00
|
|
NPV
|
$243.43
|
$7,380.92
|
|
Payback
|
2
|
2
|
Comment on why the payback period provides misleading information about Project A versus Project B.