Question

ABC Company is considering two projects. The company has funding of $230 million availble to expand its sales distribution. Project A would allow the company to expand into some new but unproven products. Project B would allow the company to expand its existing product line-up although some of the product is aging quickly. The company president wants to minmize risk since the company is running just above break-even and is, therefore, marginally profitable right now. New products have potential as the company has a good reputation for innovation, quality and service. Existing products have expereinced fierce competition of late but customers have been loyal. The required project payback period is maximum 3 years and the required return is 10%.

Project B has the following capital budgeting statistics:
           Net present value (NPV)        $42.4 Million
           Internal rate of return (IRR)   17.1%
           Payback period           3 years (Target maximum 3
years)
           Profitability index           1.18
           Average EBIT           $51.2 Million average over 5 years

Calculate the same statistics for Project A given the assumptions below:
Assumptions:
   Project life                5 years
Tax rate            50%
Discount rate (WACC)      10% required return
Interest expense           $20 Million a year
Internal rate of return (IRR)   19.6% (given)
Investment                $200.0 Million
Depreciation                $40.0 Million a year for 5 years
Working capital            $30.0 Million but reverses in Year 5
Salvage value        Zero (investment assets are worthless in 5 years)
   Operating profit (EBIT):
       Year 1           $50.0 Million
       Year 2           $70.0 Million
       Year 3           $70.0 Million
       Year 4           $70.0 Million
       Year 5           $70.0 Million
Explain, which project, is best for the company to select and discuss why

Answer 1