Capital Budget

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Cases and Exercises for Value and Capital Budgeting
Corporate Finance Academic Year 2012/2013
1. The treasurer of Amaro Canned Fruits has projected the cash flows of projects A, B and C as follows (measured in e): Year 0 Project A Project B Project C Year 1 70, 000 130, 000 75, 000 Year 2 70, 000 130, 000 60, 000

−100, 000 −200, 000 −100, 000

Suppose the relevant discount rate is 12% per annum. (a) Compute the profitability index for each of the three projects. (b) Compute the NPV for each of the three projects. (c) Suppose these three projects are independent. Which project(s) should Amaro accept, based on the profitability index rule? (d) Suppose these three projects are mutually exclusive. Which project(s) should Amaro accept, based on the profitability index rule? (e) Suppose Amaro’s budget for these projects is e 300,000. The projects are not divisible. Which project(s) should Amaro accept? (f) What would be Amaro’s choice, based on the IRR rule? 2. You are a senior manager at Airbus and have been authorised to spend up to e 200,000 for projects. The three projects you are considering have the following characteristics: Project A Initial investment of e 150,000. Cash flow of e 50,000 at year 1 and e 100,000 at year 2. This is a plant expansion project, where the required rate of return is 10%. Project B Initial investment of e 200,000. Cash flow of e 200,000 at year 1 and e 111,000 at year 2. This is a new product development project, where the required rate of return is 20%. Project C Initial investment of e 100,000. Cash flow of e 100,000 at year 1 and e 100,000 at year 2. This is a market expansion project, where the required rate of return is 20%. Assume the corporate discount rate is 10%. Please offer your recommendations, based on (a) (b) (c) (d) the payback period method; the IRR method; the profitability index method; and the NPV method.

3. Case Study: Randgold Resources plc Randgold resources plc is a London Stock Exchange gold mining and discovery firm with almost all its activities centred in Africa. This case study concerns a hypothetical gold discovery of 300,000 ounces of gold in the Mwanza region at the north tip of Tanzania. Randgold can only extract 50,000 ounces per year from the Mwanza mine and variable extraction costs are a function of the gold price. The gold price is expected to evolve as follows:

1

Cases and Exercises for Value and Capital Budgeting
Year Gold price 1 $1,070 2 $1,120 3 $1,200 4 $1,100 5 $1,000 6 $950

The discovery comes on the heels of a massive five-year exploration and discovery programme that cost $20 million. Although the exploration and discovery programme has now been completed, the firm still need to pay $8 million this year and $5 million next year (year 1) as a delayed payment to suppliers. Randgold will need to lease the land from the Tanzanian government for $10 million per annum. Mining equipment and mining quarters (spanning five miles) will need to be constructed at the cost of $70 million and this should be depreciated using 20 per cent reducing balances over the 6 year project. Assume that the equipment and mining quarters can be sold for only 20 per cent of residual value at the end of the project. The workforce will cost $10 million per annum but 30 per cent of the workforce will come from existing operations elsewhere in Africa. If the Mwanza mine is not put into operation, the workforce that comes from existing operations would lose their jobs. Working capital is expected to increase by $8 million at the start of the project and this will fall to zero at the end of the project. The effective tax rate of Randgold Resources is 28 per cent and the appropriate discount rate is 20 per cent. (a) Is it worthwhile for Randgold Resources to start production? Use three investment appraisal methods to justify your answer. (b) What are the main risk factors facing Randgold Resources in the mining project? Discuss these in detail. 4. We are evaluating a project...
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