AMERICAN INTERNATIONAL UNIVERSITY- BANGLADESHFaculty of Business Administration

Department of FinanceMBA PROGRAM

Capital Budgeting (Section B)

Assignment: 20 Marks

Due Date: February 27 2013, Wednesday (at the beginning of the class)

Students (group members) are required to solve following problems and case and submit as an assignment within the due date.

Problems to Solve: Personal Finance

1. Car Loan Problem:

If you take out a Tk. 1,500,000 car loan that calls for 48 monthly payments at an interest of 12% p.a compounded monthly, what is your monthly payment?

2. Retirement Problem:

a) A couple thinking about retirement decide to save Tk. 120,000 each year. At present they have Tk. 1,000,000 in fixed deposit savings certificates. Assume that they will enjoy a 10% p.a interest on their savings. Please answer the following:

i. How much money they will accumulate 30 years from now? ii. If their goal is to have Tk. 50,000,000, 30 years from now, how much extra they need to save per

year?

b) A couple will retire in 30 years; they plan to spend about Tk. 600,000 a year in retirement, which should last for 25 years. They believe that they can earn 8% interest on retirement savings. Assume all the payments will be made at the end of the year.

i. What will be the present value of annuity of Tk. 600,000 a year for 25 years in retirement? ii. If they make annual payments into a savings plan to accumulate the amount calculated in part (i),

how much will they need to save each year?iii. How would the answer to part (ii) change if the couple also realize that in 20 years, they will need

to spend Tk. 1,000,000 on their child’s marriage?

3. Capital Budgeting: Multiple Projects with Unequal Lives

Acclaim Entertainment, Inc. is a mass marketer of interactive entertainment software whose games can be played on such well known video game systems as Nintendo and Sega. Some of their more successful games include Mortal Kombat I and II, NBA Jam I and II, Maximum Carnage, Virtual Bart (Simpson), and NFL Quarterback. Acclaim has also obtained licenses from True Lies, Batman Forever, and Spiderman.

The interactive entertainment industry is characterized by rapid technological change and as such, no single hardware system has achieved long-term dominance. Accordingly, Acclaim focuses its production efforts on the development of software for the hardware systems that dominate the interactive entertainment market at a given point in time or in the very near future. Presently, Acclaim has licensing agreements with three industry leaders: Sony Computer Entertainment of America (SCE), Nintendo, and Sega. Acclaim is currently in the design/production stage of a new version of Mortal Kombat. Since the

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previous versions of the game were extremely successful, Acclaim is not greatly concerned with the acceptance of the game by the general public. It is concerned, however, with the hardware platform that should be chosen to distribute the game.

Since licensing agreements are extremely short term, Acclaim wonders which of the three hardware companies should carry Mortal Kombat. For example, the licensing agreement with SCE expires in December two years from now. The Nintendo agreement expires in December of this year and the Sega contract expires in December of next year. While these contracts expire and have traditionally been renewed every few years, there is no guarantee they will be successfully renewed or extended in the future.

A further consideration involves the costs charged by each company. SCE, Nintendo, and Sega charge their licensees a fixed amount per unit based on chip configuration, memory capacity, and market price. This charge covers manufacturing, printing and packaging of the unit, as well as a royalty for the use of their respective names, proprietary information and technology. Furthermore, these charges are subject to adjustment at the discretion of SCE, Nintendo, and Sega.

To offset the expenses of licensing fees, Acclaim must speculate on the ability of the three hardware platforms to access enough end-users to make their games profitable. Nintendo and Sega hold a grater share of the market, but SCE charges lower licensing fees. In general, the product life cycle in the interactive software business is from one month up to eighteen months with the majority of sales occurring within the first three months after introduction. Although titles older than eighteen months may still be available for sale, Acclaim generally actively markets only its ten to fifteen most recently released titles. Mortal Kombat represents somewhat of an exception to the rule. Being one of the most successful products, Mortal Kombat's most feared competitor will be the prospect of the next version of Mortal Kombat. There has currently been no discussion of the number of games that will be produced in the series.

Acclaim's management has assembled the following projected net cash flows associated with the distribution of Mortal Kombat. These net cash flows reflect all licensing fees, productions costs, advertising expenditures, revenues, etc.

Table 1:Time (end of year)

Net Cash Flow (in millions)SCE Nintendo Saga

0 -$40 -$40 -$401 $34 $44 $412 $10 $16 $183 $5 $44 $1

Questions

1. What is the Payback Period for Mortal Kombat when marketed under the three different hardware companies? Assuming a required payback period of 1 year, which company would you allow to carry the new product?

2. Assuming a discount rate of 10%, what is the Net Present Value (NPV) under each system? Under which system, if any, would you be willing produce Mortal Kombat?

3. What are the Internal Rates of Return (IRR) under each marketer? Which marketer(s) has/have acceptable IRRs?

4. Thus far we have assumed that Mortal Kombat will be marketed through only one hardware system. Under this assumption, the projects are mutually exclusive. If we explore the possibility of allowing more than one company to market Mortal Kombat, which company(ies) would you allow to market the product? Base your answer on the three criteria from the above questions.

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5. Mortal Kombat will have a different life span depending on the hardware system Acclaim chooses. Since the lives of the three projects are not equal, can a comparison truly be made based on conventional NPV measures? Calculate the Annualized Net Present Value (ANPV) for each of the three alternatives. Based on ANPV, which marketer would you choose to sell the product through if the projects were mutually exclusive? What if they were independent?

4. Capital Budgeting: One Project - Accept/Reject Decision

The airline industry is extremely cyclical. That is, when the economy does well, so too do airlines. In recent years, the airline industry has found itself with too many seats and too few passengers. Some experts point to the past deregulation of the industry while others argue that technological advances such as teleconferencing are responsible. Several airlines such as Continental, America West, Eastern, and Trans World Airlines, have filed for Chapter 11 Bankruptcy. Some have fully recovered, while others have been forced to liquidate. Narrowing profit margins have prompted airlines to develop creative survival tactics. Southwest Airlines has successfully found its niche in the industry by providing direct flight service to less travelled routes such as those to and from smaller cities. Since these routes do not generate nearly as much revenue as major city routes, Southwest has found ways to reduce its costs. Costs are reduced by following a no frills policy that the travellers refer to as "peanut flights." This means that instead of serving costly meals (the quality of which passengers have historically complained about anyway), Southwest serves just a bag of peanuts and a soft drink. With the recent success of short, direct flights, Southwest is considering the purchase of one such additional route.

Before an airline applies to the federal government for a new route, a lengthy analysis is performed to determine the feasibility of the route. Expenses to consider include airport costs such as gate and landing fees and labour costs such as local baggage handlers and maintenance workers. Many times the airline will provide its own employees to load and unload luggage or to provide upkeep for their planes, but in the case of Southwest, they have so many small cities to service that the outsourcing of these jobs is not uncommon.

Table 1 provides a summary of the after-tax cash flows associated with the acquiring of an additional small route. All costs and revenues are reflected by the following numbers.

Table 1: Projected Net Cash flows (in Millions of Dollars)

Year Net Cash flow0 -$20.81 $4.52 $6.33 $5.24 $3.95 $2.16 $1.37 $0.5

Questions:

1. What is the project's NPV assuming Southwest has a discount rate of 10%? How do we interpret the NPV?

2. What is the project's IRR? How is this measure different from the NPV? What is the interpretation of this number?

3. Calculate the project's Payback Period.

4. Assuming that Southwest has a required payback period of 5 years and a hurdle rate of 10%, should Southwest accept the additional route? Based on the project's NPV, should it be accepted? If conflicting conclusions occur, which criteria would you follow?

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5. When will conflicts likely occur among the three criteria?

6. Calculate the project's Modified Internal Rate of Return (MIRR). What critical assumption does the MIRR make that differentiates it from the IRR?

7. Where does the value of MIRR fall relative to the discount rate and IRR?

*** Important Notes:

The assignment must be submitted in the beginning of the class on the due date. If the group does not submit the assignment at the beginning of the class, a lower grade will be given.

All group members must participate preparing the group assignment. The course teacher will randomly ask group members for their contribution and understanding of the topic discussed in the assignment.

In case of delay in submission, 1(one) mark per day will be deducted.

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