Question

Your first assignment in your new position as assistant financial analyst at Caledonia Products is to evaluate two new​ capital-budgeting proposals. Because this is your first​ assignment, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at assessing your understanding of the​ capital-budgeting process. This is a standard procedure for all new financial analysts at​ Caledonia, and it will serve to determine whether you are moved directly into the​ capital-budgeting analysis department or are provided with remedial training. The memorandum you received outlining your assignment​ follows:

​To: New Financial Analysts

​From: Mr. V.​ Morrison, CEO, Caledonia Products

​Re: Capital-Budgeting Analysis

Provide an evaluation of two proposed​ projects, both with

55​-year

expected lives and identical initial outlays of

​$150 comma 000150,000.

Both of these projects involve additions to​ Caledonia's highly successful Avalon product​ line, and as a​ result, the required rate of return on both projects has been established at

1313

percent. The expected free cash flows from each project are shown in the popup​ window:

LOADING...

.

In evaluating these​ projects, please respond to the following​ questions:

a. Why is the​ capital-budgeting process so​ important?

b. Why is it difficult to find exceptionally profitable​ projects?

c. What is the payback period on each​ project? If Caledonia imposes a

44​-year

maximum acceptable payback​ period, which of these projects should be​ accepted?

d. What are the criticisms of the payback​ period?

e. Determine the NPV for each of these projects. Should either project be​ accepted?

f. Describe the logic behind the

NPV.

g. Determine the PI for each of these projects. Should either project be​ accepted?

h. Would you expect the NPV and PI methods to give consistent​ accept/reject decisions? Why or why​ not?

i. What would happen to the NPV and PI for each project if the required rate of return​ increased? If the required rate of return​ decreased?

j. Determine the IRR for each project. Should either project be​ accepted?

k. How does a change in the required rate of return affect the​ project's internal rate of​ return?

l. What reinvestment rate assumptions are implicitly made by the NPV and IRR ​methods? Which one is​ better?

	PROJECT A		PROJECT B		Copy to Clipboard + Open in Excel +
Initial outlay	−​$150,000		−​$150,000
Inflow year 1	10,000		40,000
Inflow year 2	30,000		40,000
Inflow year 3	30,000		40,000
Inflow year 4	50,000		40,000
Inflow year 5	70,000		40,000

Answer 1

As per rules I am answering the first 4 subparts of the question

A: The capital budgeting process is extremely important because it involves a huge amount of funds which gets locked for a large period of time. Hence the decision has to be made very carefully because it is a long-term decision and also an incorrect decision can lead to heavy losses as well as opportunity lost to the firm.

B: exceptionally profitable projects are hard to find because of changing economy. At times the project may seem profitable at first but changes in consumer preferences and demands may make the project unprofitable. Also the presence and entry of competitors make projects unprofitable.

C:Payback of Project A = 4.43 years

Payback of project B = 3.75 years

Only accept Project B

D: the payback period method though simple to apply, ignores the time value of money. It also makes a decision on the basis of cost recovery and ignores the cash flows after the payback period.

WORKINGS

	PROJECT A	Cumulative CF	PROJECT B	Cumulative CF
Initial outlay	-150000	-150000	-150000	-150000
Inflow year 1	10000	-140000	40000	-110000
Inflow year 2	30000	-110000	40000	-70000
Inflow year 3	30000	-80000	40000	-30000
Inflow year 4	50000	-30000	40000	10000
Inflow year 5	70000	40000	40000	50000
Payback	4.43		3.75

Payback = Year in which Cumulative CF is last negative -(Last negative cumulative CF/ CF of next year