Question

1. 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 chief financial officer (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 that 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 net cash flows (in thousands of dollars):

   Expected Net Cash Flows

   Year	Project L	Project S
   0	($200)	($200)
   1	20	140
   2	120	150
   3	170	20

   Depreciation, salvage values, net 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 NPV of each project? According to NPV, which project(s) should be accepted if they are independent? Mutually exclusive?
   2. What is the IRR of each project? According to IRR, which project(s) should be accepted if they are independent? Mutually exclusive?
   3. What is the payback period for each project? According to the payback criterion, which project(s) should be accepted if the firm’s maximum acceptable payback is two years if Projects L and S are independent?
   4. What are the two main disadvantages of discounted payback? Is the payback method useful in capital budgeting decisions? Explain.
2. Colsen Communications is trying to estimate the first-year cash flow (at Year 1) for a proposed project. The assets required for the project were fully depreciated at the time of purchase. The financial staff has collected the following information on the project:
   • Sales revenues: $ 20 million
   • Operating costs: 14 million
   • Interest expense: 2 million
3. The company has a 30% tax rate, and its WACC is 14%. What is the project’s cash flow for the first year?

Answer 1

1) What is NPV of each project

NPV of Project L -

Year	Project L Cash Flow - A	Discounting factor @10% - B	PV AxB
0	$           (200)	1.000	$ (200.00)
1	$                20	0.909	$      18.18
2	$              120	0.826	$      99.17
3	$              170	0.751	$   127.72
		NPV (Sum)	$      45.08

NPV of Project S -

Year	Project S Cash Flow - A	Discounting factor @10% - B	PV AxB
0	-200	1.000	$ (200.00)
1	140	0.909	$   127.27
2	150	0.826	$   123.97
3	20	0.751	$      15.03
		NPV (Sum)	$      66.27

Discounting factor = 1/(1+i)^n
i = Discounting rate (in this case 10%)
n = Period (in thi case 1 to 3).

Conclusion - Based on the NPV analysis, Project S should be accepted.

2) What is the Internal Rate of Return (IRR) for both the projects.

IRR can be found out by using the IRR function formula in excel [i.e (=IRR(cashflow year1, cashflow year 2, cashflow year 3). Alternatively, it can be found using trial and error mehod.

Based on the excel formula, IRR for Project L - 20% and IRR for Project S - 32%.

Conclusion - Based on the IRR analysis, Project S should be accepted.

3) What is the payback for both the projects.

Payback period is the time when the cumulative cash flow turns zero. Cumulative cash flow for Project L is given below -

Year	Project L Cash Flow	Cumulative CF
0	$         (200)	$          (200)
1	$              20	$          (180)
2	$           120	$            (60)
3	$           170	$            110

Cumulative cash flow becomes positive between Year 2 and Year 3.

Payback = Year in which the cashflow is postive+(cumulative cash flow for year 2/Cash flow for year 3)

Payback for Project L = 2+60/170 = 2.35 years.

Cumulative cashflow for Project S

Year	Project S Cash Flow	Cumulative CF
0	-200	$      (200)
1	140	$        (60)
2	150	$          90
3	20	$        110

Payback for Project S = 1+(60/150)

Payback = 1.40 years.

Conclusion - Based on the payback, Project S should be accepted. Project L has a payback of more than 2 years and as per the company plicy, it cannot be accepted.

4)

i) Disadvantages of Discounted payback -

a) Discounted payback doesnot consider the cash flows beyond the break even point.

b) Discounted payback fails to determine whether the firms value will increase or not.

ii) Is payback method useful in capital budgeting.

Payback one of the useful capital but is not a great capital budgeting tool. it has lot of limitations. It doesnt consider time value of money. It doesnt analyse beyond the break even point. Payback can be used as a preliminary tool to check if the project is vaible or not. But it cannot be fully relied upon.

5) Wat is the Year 1 cashflow.

Particulars	Amount in $ in million
Sales Revenue	20.0
Less: Operating cost	14.0
Earnings Before Tax	6.0
Less: Tax @30%	1.8
Free Cash Flow	4.2

Note: Since Weighted Average Cost of Capital (WACC) is used, interest should be not considered as an expenese for the purpose of arriving at the free cash flow. WACC already inbuilts the interest component on the debt.