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 here:

	PROJECT A	PROJECT B
Initial Outlay	- $130,000	- $130,000
Inflow year 1	20,000	40,000
Inflow year 2	30,000	40,000
Inflow year 3	50,000	40,000
Inflow year 4	60,000	40,000
Inflow year 5	60,000	40,000

In evaluating these​ projects, please respond to the following​ questions:

a. The​ capital-budgeting process is so important because c​apital-budgeting decisions involve investments requiring rather _______(small, moderate, large) cash outlays at the beginning of the life of the project and commit the firm to a particular course of action over a relatively ________(short, intermediate, long) time horizon.

b. Why is it difficult to find exceptionally profitable​ projects?  

A. There is no reliable method to accurately estimate a​ project's future cash flows.

B. The lack of effective investment criteria makes profitable projects hard to find.

C. The existence of competition may drive price and profit down quickly.

D. The costs of implementing​ capital-budgeting decisions are extremely high.

c.   - What is the payback period on project​ A?

• If Caledonia imposes a 4​-year maximum acceptable payback​ period, the firm should ___(accept, reject) project A because its payback period is ______(less than or equal to, greater than) the maximum acceptable payback period.

• What is the payback period on project​ B?

• If Caledonia imposes a 4​-year maximum acceptable payback​ period, the firm should ______(accept, reject) project B because its payback period is ______(less than or equal to, greater than) the maximum acceptable payback period.

d. What are the criticisms of the payback​ period?

A. It is consistent with the​ firm's goal of shareholder wealth maximization.

B. The selection of the maximum acceptable payback period is arbitrary.

C. The method does not take into account the time value of money.

D. The method ignores cash flows occurring after the payback period.

e. - What is the NPV of project​ A?

• Caledonia should ____(accept, reject) project A because its NPV is _____(greater than or equal to, less than) zero.

• What is the NPV of project​ B?

• Caledonia should ____(accept, reject) project B because its NPV is ____(greater than or equal to, less than) zero.

f. Which of the following statements best describes the logic behind the NPV​?

A. The net present value technique computes the number of years it takes to recapture a​ project's initial outlay using discounted cash flows.

B. The net present value technique finds the discount rate that equates the present value of the​ project's free cash flows with the​ project's initial cash outlay.

C. The net present value technique calculates the ratio of the present value of the future free cash flows to the initial outlay.

D. The net present value technique discounts all the benefits and costs in terms of cash flows back to the present and determines the difference.

g. - What is the PI for project​ A?

• Caledonia should ____(accept, reject) project A because its PI is ____(greater than or equal to, less than) 1.00.

• What is the PI for project​ B?

• Caledonia should (accept, reject) project B because its PI is (greater than or equal to, less than) 1.00.

h. Would you expect the NPV and PI methods to give consistent​ accept/reject decisions?

A. The NPV and the PI always give different decisions. The​ project's PI is greater than 1.00 if the NPV is negative and​ it's less than 1.00 if the NPV is positive.

B. The NPV and the PI always give the same decision. The​ project's PI is greater than 1.00 if the NPV is negative and​ it's less than 1.00 if the NPV is positive.

C. The NPV and the PI always give the same decision. The​ project's PI is greater than 1.00 if the NPV is positive and​ it's less than 1.00 if the NPV is negative.

D. The NPV and the PI always give different decisions. The​ project's PI is greater than 1.00 if the NPV is positive and​ it's less than 1.00 if the NPV is negative.

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?

A. NPV and PI will not be affected by the change in the required rate of return.

B. NPV will be affected by the change in the required rate of​ return, but PI will not.

C. PI will be affected by the change in the required rate of​ return, but NPV will not.

D. Both NPV and PI will be affected by the change in the required rate of return.

j. - What is the IRR for project​ A?

• Caledonia should ____(accept, reject) project A because its IRR is _____(greater than or equal to, less than) the 12​% required rate of return. 

• What is the IRR for project​ B?

• Caledonia should ___(accept, reject) project B because its IRR is ___(greater than or equal to, less than) the 12​% required rate of return. 

k. How does a change in the required rate of return affect the​ project's internal rate of​ return?

A. The required rate of return does not only change the IRR for a​ project, but it also affects whether a project is accepted or rejected.  

B. The required rate of return does change the IRR for a​ project, but it does not affect whether a project is accepted or rejected.  

C. The required rate of return does not change the IRR for a​ project, neither does it affect whether a project is accepted or rejected.  

D. The required rate of return does not change the IRR for a​ project, but it does affect whether a project is accepted or rejected. 

l. What reinvestment rate assumptions are implicitly made by the NPV and IRR ​methods? Which one is​ better? 

A. The NPV assumes that all cash flows over the life of the project are reinvested at the required rate of return​ and, thus, is preferred.

B. The IRR assumes that all cash flows over the life of the project are reinvested over the remainder of the​ project's life at the internal rate of return​ and, thus, is preferred.

C. The NPV assumes that all cash flows over the life of the project are reinvested over the remainder of the​ project's life at the internal rate of return​ and, thus, is preferred.

D. The IRR assumes that all cash flows over the life of the project are reinvested at the required rate of return​ and, thus, is preferred.

Answer 1

Answer (a):

The​ capital-budgeting process is so important because c​apital-budgeting decisions involve investments requiring rather large cash outlays at the beginning of the life of the project and commit the firm to a particular course of action over a relatively long time horizon.

Answer (b):

Correct answer is:

C. The existence of competition may drive price and profit down quickly.

Explanation:

Statement A and B are incorrect since there are reliable methods to evaluate project and companies have set investment criteria.

Profitable projects attracts competition and Competition  may drive price and profit down quickly. As such statement C is correct.

Answer (c):

Payback period of project A = 3.50 years

If Caledonia imposes a 4​-year maximum acceptable payback​period, the firm should accept project A because its payback period is less than the maximum acceptable payback period.

Working:

Payback period on project​ B is = 3.25 Years

If Caledonia imposes a 4​-year maximum acceptable payback​period, the firm should accept project B because its payback period is less than the maximum acceptable payback period.

Working:

Payback period of project B = Initial Investment /Annual cash flow = 130000 / 40000 = 3.25 Years

Answer (d):

Correct Choices are:

C. The method does not take into account the time value of money.

D. The method ignores cash flows occurring after the payback period.

Explanation:

Statement C and D are major criticisms of payback period.

Statement A is incorrect since payback period may reject potentially good projects in terms of value addition to shareholders.

Statement B is incorrect since investors sets criteria as in what time line they would like to recover their investments.

Answer (e):

NPV of project​ A = $19,538.67

Caledonia should accept project A because its NPV is greater than zero.

For working of NPV of project, please refer to table in answer c above.

NPV of project B is = $14,191.05

Caledonia should accept project B because its NPV is greater than zero.

Working:

NPV of project B = Annual cash flow * PV of $1 annuity for 5 years at 12% rate - Initial investment

= 40000 * (1 - 1 /(1+12%)^5)/12% - 130000

= $14191.05

As HOMEWORKLIB's policy 4 parts need to be answered; I have already answered 5 parts.