In: Finance
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?
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.