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 $130,000. 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 12 percent. The expected free cash flows from each project are shown in the popup​ window:

PROJECT A   PROJECT B
Initial outlay   -130,000   -130,000
Inflow year 1   10,000   40,000
Inflow year 2   40,000   40,000
Inflow year 3   40,000   40,000
Inflow year 4   40,000   40,000
Inflow year 5   60,000   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 3-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

a. Capital Budgeting is important because an organisation has limited resources and Capital Investment requires a large number of funds and the correct decision of such decisions would help in sustaining the growth of the business. Such investments involved are replacement of machinery or purchase of machinery which is required in improving the efficiency of operations. Capital Budgeting identifies the research and development expenditure and necessary expenditure for a necessary project. A number of decisions have to be taken while implementing a capital budgeting process and this helps in facilitating the transfer of information to the appropriate decision makers in the company.

b. In competitive markets, large profits cannot exist for very long because of the competition in the existing market. Profitable projects can be found only only when there is there is less competition in the existing market. The amount of competition by a large amount of players reduces the profit and exceptionally profitable projects are difficult to find and are sought after by every company in the industry. One way to find achievable projects is when there is product differentiation which is very difficult to achieve in the present scenario.

c. Payback Period for Project A = Time taken to recover the project = 4 years

Payback Period for Project B = Time taken to recover the project = 3 + 10000/40000 years = 3.25 years

If Caledonia imposes a 3-year maximum acceptable payback​ period, none of these projects should be​ accepted because the payback period exceeds the maximum period set by the company.

d. The biggest disadvantage of payback period is that ignores the time value of money and does not consider the amounts received on the project after the payback period. The project may have higher returns because of cash flows received after the project may have higher values and does not consider the cash inflows after the payback period.