Question

You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler AG, Ford, Toyota, and other automakers. Your boss, the CFO, has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would 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 Allied is planning to introduce entirely new models after 3 years.

Here are the projects’ after-tax cash flows (in thousands of dollars):

                                   0                      1                      2                      3

                                    |                       |                       |                       |

Project L                 -100                    10                   60                    90

Project S                  -100                    70                   50                    10

Depreciation, salvage values, net operating working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted.

1- What is the Payback Period for Project S?

2- Which of the following is NOT a critical deficiency of regular payback?

1. Ignores Time Value of Money (TVM)
2. Ignores the Cash Flows after the Payback period
3. Payback only tells us when we get our investment back, does not yield wealth creation data like NPV and IRR.
4. Provides indication of project’s risk and liquidity

3- Find the crossover rate between project L and project S.

Answer 1

1.
=1+(100-70)/50
=1.6000000

2.
Provides indication of project’s risk and liquidity

3.
=IRR({0;-60;10;80})
=24.1037%