Question

IL.Cupi D . Provide an evaluation of two proposed projects, both with 5-year expected identical initial outlays of $110,000. Both of these projects involve additions donia's highly successful Avalon product line, and as a result, the require return on both projects has been established at 12 percent. The expected fre flows from each project are as follows: ected lives and additions to Cale- required rate of xpected free cash Initial outlay Inflow year 1 Inflow year 2 Inflow year 3 Inflow year 4 Inflow year 5 PROJECT A -$110,000 20,000 30,000 40,000 50,000 70,000 PROJECT B -$110,000 40,000 40,000 40,000 40,000 40,000 In evaluating these projects, please respond to the following questions: a. Why is the capital-budgeting process so important? b. Why is it difficult to find exceptionally profitable projects? c. What is the payback period on each project? If Caledonia imposes a 3-year maximum acceptable payback period, which of these projects should be accepted? d. What are the criticisms of the payback period? e. Determine the NPV for each of these projects. Should either project be accepte f. Describe the logic behind the NPV. g. Determine the PI for each of these projects. Should either project be accep h. Would you expect the NPV and PI methods to give consistent accepter decisions? Why or why not? i. What would happen to the NPV and PI for each project if the require return increased? If the required rate of return decreased? j. Determine the IRR for each project. Should either project be accepte the required rate of

Answer 1

a)

Capital Budgeting process evaluates a project feasibility by comparing the investment amount to the various parameters used to measure whether the project is acceptable or not. This helps the firm to understand which alternatives are worth pursuing to increase the shareholder value and thereby increasing the firm value.

b)

Projects are risky endeavour requiring managerial and technical skills to convert the opportunity into profits and returns to investors. If a project is exceptionally profitable, then there would be a large number of firms pursing the same opportunity and in time there would be far and few such project to choose from. Moreover, the costs of acquiring such projects would be high.

c)

Project A and Project B Project A Cash flows Cumulative cash flows Payback period -110000 -110000 20000 -90000 30000 -60000 40000 -20000 50000 30000 70000 100000 3.40 Project B Cash flows Cumulative cash flows Payback period -110000 -110000 40000 -70000 40000 -30000 40000 10000 40000 50000 40000 90000 2.75

As project B has payback period less than 3 , it should be accepted and Project A rejected.

d)

Payback period does not use time value of money concept and as such considers that all cash flows occurring at a later point of time is quantified without discounting. This is an anomaly in finance as time value is crucial when considering future cash flows.

Formulae

G =F328+1 =C328+1 =D328+1 =E328+1 =G328+1 328 Project A and Project B 329 Project A 330 Cash flows 331 Cumulative cash flows 332 Payback period -110000 =B331+C330 20000 =C331+D330 30000 =D331+E330 40000 =E331+F330 50000 =F331+G330 70000 =G331+H330 =F328-(F331/G330) 333 334 Project B 335 Cash flows 336 Cumulative cash flows 337 Payback period -110000 =B336+C335 40000 =C336+D335 =D335 =D336+E335 =E335 =E336+F335 =F335 =F336+G335 =G335 =G336+H335 =E328-(E336/F335)