Question

In: Finance

Your first assignment in your new position as assistant financial analyst at Caledonia Products is to...

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

5-year expected lives and identical initial outlays of ​$150,000. 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 16 percent. The expected free cash flows from each project are shown in the popup​ window:

PROJECT A

PROJECT B

Initial outlay

-150,000

−​$150,000

Inflow year 1

       10,000

       40,000

Inflow year 2

       40,000

       40,000

Inflow year 3

       30,000

       40,000

Inflow year 4

       60,000

       40,000

Inflow year 5

       80,000

       40,000

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?

Solutions

Expert Solution

1. Capital Budgeting is important due to many reasons which are a) capital budgeting involves huge investment therefore it is very important to make decisions after a thoughtful consideration any incorrect decision may result in huge losses and account for failure of firm. b) Decisions have long term effect and influences growth rate of firm. c) Investment decisions are irreversable once taken cannot be reverse back.

2.It is difficult to find exceptionally profitable project because of competiton to find such a project the company must think out of the box different from others even if a company finds a profitable project competitors try to try the same which results in reduction of profits and return due to which a highly profitable project doesnt gurantee a long future.

3. Payback period = Project A

Year Cash flow Cumulative cash flow
1 10000 10000
2 40000 50000
3 30000 80000
4 60000 140000
5 80000 220000

Payback period = 4 + 150000 - 140000 / 80000

4.12 years

Project B

Initial Investment / Cash flow each year

= 150000/ 40000

= 3.75 years

Since project B has low payback period it should be accepted.

4. Critism of payback period is that it ignores time value of money. As long as payback period of two projects are same it considers them equal investment even if one project generates most of its cash flows in early years while other generates most of its cash flows in latter years.


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