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

5-year expected lives and identical initial outlays of 110,000.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 13 percent. The expected free cash flows from each project are shown in the popup​ window:

	PROJECT A		PROJECT B
Initial outlay	−110,000		−​110,000
Inflow year 1	10,000		40,000
Inflow year 2	30,000		40,000
Inflow year 3	40,000		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

4​-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?

Answer 1

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

a: The capital budgeting process involves a large amount of outlay. This amount is invested in fixed assets and stays locked for a long period of time. Hence assessing the projects carefully is important for which the capital budgeting process has to be performed in detail.

b: exceptionally profitable projects are hard to find because of economic and financial changes, changes in customer demand and preferences and uncertainty about the future. Moreover the present value of projects is taken into account which depends upon the opportunity cost of capital. Higher this cost lower will be the present value and vice versa.

C: payback of project A = 4.125 years

Payback of project B = 3.75 years

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

D: the payback method is criticized on the following grounds

1: it does not take into account the time value of money.

2: it only compares projects on the basis of recovery period and ignored the net value added.

3: this method neglects the cash flows which occur after the payback period.

WORKINGS