Question

Your boss, the chief financial officer (CFO) for Southern Textiles, has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s fabric line. It would take some time ti build ip the marketnfie this product, sonthe cash inflows woukd increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives because Southern is planning to introducenan entirely new fabric at that time.

Here are the net cash flow estimates (in thousands of dollars):

Expectes Net Cash Flows

Year. Project L. Project S

0. $(100). $(100)

1. 10. 70

2. 60. 50

3. 80. 20

The CFO also made subjective risk assessments of each project, and he concluded that the projects both have risks characteristics that are similar to the firms average project. Southern’s required rate of return is 10%. You must now determine whether one or both of the projects should be accepted. Start by answering the following questions:

a. What is capital budgeting? Are there any similitaries between a firm’s capital budgeting decisions and individual’s investment decisions?

b. What is the difference between independent and mutually exclusive projects? Between projects with conventional cash flows and projects with unconventional cash flows?

c. (1) Whatnisnthe payback period? Findnthe traditional payback measure? According to the payback criterion, which project or projects should be accepted if the firm’s maximum acceptable payback is two years and Project L and Project S are independent? Mutually exclusive?

(3) What is the differencenbetweenbthe traditional payback and the discounted payback? What is each project’s discounted payback?

(4) What are the main disadvantages of the traditional payback? Is the payback method of any real usefulness in capital budgeting decisions?

d. (1) Define the term net present value (NPV). What is each project’s NPV?

(2) What is the rationale behindnthe NPV method? According to NPV, which project or projects should be accepted if they are independent? Mutually exclusive?

(3) Would the NPVs changenifnthe requirednratenof return changed?

Answer 1

(a): Capital budgeting is a strategic allocation process in which a company identifies potential investment opportunities, assembles the proposed investments, and then make decisions. In simple words capital budgeting is that process which a firm undertakes so as to be able to evaluate different projects in which it can make investments. Yes, there are similarities between a firm’s capital budgeting decisions and individual’s investment decisions. In both cases the investments are ranked as per pre-set criteria and the funds are parked in those investments that will lead to maximum benefits or greatest returns.

(b): Independent projects are those projects whose cash flows have no impact on the acceptance or rejection of other projects. Projects are mutually exclusive if acceptance of any one of the project will lead to rejection of other projects. Thus in case of independent projects all those projects will be selected that meet the investment criteria. However if two projects are mutually exclusive then both the projects cannot be selected and only the best project will be selected.

Conventional cash flows refer to cash flows in which there is an initial cash outflow followed by a series of cash inflows. Unconventional cash flows are those in which cash outflows occur even in subsequent years. Thus in case of conventional cash flows there is only one change in the cash flow direction but in case of an unconventional cash flow there is more than one change in the cash flow direction.

(c )(1) : Payback period is the length of time required to recover the initial cash outlay on the project.

Year	L's cash flow	Cumulaive cash flow of L		S's cash flow	Cumulaive cash flow of L
0	-100	-100		-100	-100
1	10	-90		70	-30
2	60	-30		50	20
3	80	50		20

L's payback = 2+(30/80) = 2.375 years. S's payback = 1+(30/50) = 1.60 years

In case the projects are independent the criteria of a payback of 2 years is met by project S only and hence project S will be selected. In case of mutually exclusive projects as well S will be selected.

	Selected project
Independent	Project S
Mutually exclusive	Project S

(c) (3): The difference between traditional payback and the discounted payback is that in case of discounted payback time value of money is considered while it is not so the case with the traditional pay back method.

Year	L's cash flow	Cumulaive cash flow of L	1+r	PVIF	PV of L's cash flow	Cumulative discounted cash flow of L		S's cash flow	PV of S's cash flow	Cumulative discounted cash flow of S
0	-100	-100	1.1	1.000000000	-100.000	-100.000		-100	-100	-100
1	10	-90		0.909090909	9.090909091	-90.9090909		70	63.63636364	-36.3636364
2	60	-30		0.826446281	49.586776860	-41.3223140		50	41.32231405	4.958677686
3	80	50		0.751314801	60.105184072	18.782870		20	15.02629602

L's discounted payback = 2+(41.322314/60.105184) = 2.6875 years

S's discounted payback = 1+(36.363636/41.32231) = 1.88 years

(4) The main disadvantage of traditional payback is that it fails to consider the time value of money. The cash flows are not discounted to factor in the time value of money. The payback method is not that much useful in capital budgeting decisions as the NPV and IRR methods are regarded as superior methods and hence are used more often.

(d) (1): NPV is the sum of all present values of all the cash flows - positive as well as negative - that are expected to occur over the life of the project.

Year	L's cash flow	1+r	PVIF	PV of L's cash flow		S's cash flow	PV of S's cash flow
0	-100	1.1	1.000000000	-100.000		-100	-100
1	10		0.909090909	9.090909091		70	63.63636364
2	60		0.826446281	49.586776860		50	41.32231405
3	80		0.751314801	60.105184072		20	15.02629602
			NPV	18.783			19.985

(2): The rationale behind the NPV method is that if a project has NPV>0 then the project is creating value as the present value of cash inflows > the present value of cash outflows.

If projects are independent then both the projects will be selected as their NPVs>0.

If projects are mutually exclusive then only project S will be selected as its NPV is greater.

(3) Yes NPV will change if required rate of return is changed. NPV will fall if rate is increased and NPV will increase if rate is reduced.