Question

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

A. 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

B. Explain, which project, is best for the company to select and discuss why

Answer 1