Question

1. You recently went to work for United Motors Company, a supplier of auto repair parts used in the after-market with products from Dodge, Fiat, Jeep, and other auto makers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects.

Project X 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 Y involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives, because United Motors is planning to introduce entirely new models after 3 years.

Here are the projects’ net cash flows (in millions of SAR):

Years	Project X	Project Y
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 both projects have risk characteristics that are similar to the firm’s average project. United’s WACC is 10%.  You must now determine whether one or both of the projects should be accepted.           

What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? Define the term net present value (NPV). What is each project’s NPV? What is the rationale behind the NPV method? According to NPV, which project or projects should be accepted? Would the NPVs change if the WACC changed?

Answer 1

A) Capital budgeting : is a process that a business uses to determine which proposed fixed asset purchases it should accept, and which should be declined.

Both the capital budgeting and investment decsions based on the same principal of TIme value. i.e you discount the future cashflows as per rate . This will help to determine whether the investment done is feasable or not

B) NPV : Net Present Value is the Difference between the Inital investment and the present value of the future cash flows.

In our example : PRoject X has inital Investment of 100

Present Value of future Cashflows : = 118.78

118.78-100= 18.78

Project Y =119.98

119.98-100=19.98

C) NPV gives an estimate of the present value of the firm through discounting the future cashlows to present and using present inital investment . How much does thes project produce in present value terms

NPV greater than 0 should be accpeted , as they are abble to provide you with the future gains . If NPV is less than 0 the project should not be accepted as overall the project would lead to loss.

D) Yes, if WACC changes the NPv will change . WACC is the rate through which we are discounting the future cash flows . If we change it then Present value of future cashflows changes and hence the NPV

In our example both of them can be accepted as both of them are greater than 0. But, if you have to choose one , Choose the one with greater NPV ie PRoject Y