Question

Michael Wright graduated from the University College in June and has been working for about a month as a junior financial analyst at Caledonia Products Ltd. When Michael arrived at work on Monday morning, he found the following memo in his e-mail.

TO:               Michael Wright

FROM:         V. Morrison, CFO, Caledonia Products Ltd.

RE:               Capital Budgeting Analysis

Provide an evaluation of the three proposed projects whose cash flow forecasts are found below:

                                                Product A                  Product B                   Product C                           

Initial cost                               $760,000                     $650,000                     $512,000

Expected life                           5 years                         5 years                         4 years

Scrap value expected              $30,000                       $35,000                       $20,000

Expected cash inflows:                 $                                    $                              $

Year

1                                              320,000                          200,000                   200,000

2                                              300,000                          240,000                   210,000

3                                              240,000                          210,000                   180,000

4                                            320,000                          260,000                   160,000

5                                              180,000                          180,000                  

Since these projects involve additions to Caledonia’s highly successful Avalon product line, the company uses the WACC of the line to evaluate the additions. The projects are independent.

           1. Cost of Debt is 15.63% and the tax rate is 20%;

           2. The dividend paid out for preference shares is $6. Each share

              currently trades at $21 and has a floatation cost of $3;

           3. Ordinary shares receive a dividend of $1.50 per share. It has

              growth rate of 10% and it is currently trading at $15 with a

              floatation cost of $2.31.

Note:

The Debt : Preference Shares : Ordinary Shares ratio is 3 : 2 : 5

Give me your thoughts on these three projects by 10 am on Wednesday Morning.

Michael was not surprised by the memo, for he had been expecting something like this for some time. Caledonia followed a practice of testing each of their new financial analyst with some type of project evaluation exercise after they have been on the job for a few months. After re-reading the memo, Michael decided on his plan of action and made up the following “to do” list:

Calculate for each project:

1. The payback period for each project                                                                            6 marks
2. The Net Present value (NPV)                                                                                      10 marks
3. The Profitability Index (PI)                                                                                          9 marks
4. Which project should be accepted and why?                                                               4 marks

Later that day Michael was approached again by the CFO about the following, which is to be added to the report previously requested:

To absorb some short-term excess production capacity at its plant, the company is considering a short manufacturing run for either of two new products, a temperature sensor or a pressure sensor. The market for each product is known if the products can be successfully developed. However, there is some chance that it will not be possible to successfully develop them. Revenue of $1,000,000 would be realized from selling the temperature sensor and revenue of $400,000 would be realized from selling the pressure sensor. Both amounts are net of production cost but do not include development cost. If development is unsuccessful for a product, then there will be no sales, and the development cost will be totally lost. Development cost would be $100,000 for the temperature sensor and $10,000 for the pressure sensor. The probability that the development of the sensor will be successful is 0.50 for the temperature sensor and 0.80 for the pressure sensor.

1. Construct a decision tree showing all the options available, the revenue and payoff for each option and the probability of success and failure for each option.                                  (11 marks)

           

Prepare Michael’s assignment for his Wednesday meeting with the CFO by filling out your response to the “to do” list above.                  

Answer 1

A.PAYBACK PERIOD :

For Product A

Year	Year 0	Year 1	Year 2	Year 3	Year 4
ATCF	-7,60,000	3,20,000	3,00,000	2,40,000	3,20,000	2,10,000
Cumulative ATCF	-7,60,000	-3,20,000	-20,000	2,20,000	5,40,000	7,50,000

As you can see, in year 3, the cumulative cash flow sign changes from negative to positive, meaning that at some point between year 2 and 3, costs would be recovered by generated profit.So, the payback period is somewhere in year 2.To calculate the fraction, we can simply divide the 20,000 (cumulative cash flow in year 2) by 2,40,000 (cash flow in year 3). Therefore the payback period equals: 2+20,000/2,40,000= 2.083 years

For Product B

Year	Year 0	Year 1	Year 2	Year 3	Year 4
ATCF	-6,50,000	2,00,000	2,40,000	2,10,000	2,60,000	2,15,000
Cumulative ATCF	-6,50,000	-4,50,000	-2,10,000	0	2,60,000	4,75,000

As we can see that in Year 3, we can see that Cumulative Cash Flows Became Zero.Therefore the payback period is 3 years

For Product C

Year	Year 0	Year 1	Year 2	Year 3	Year 4
ATCF	-5,12,000	2,00,000	2,10,000	1,80,000	1,80,000
Cumulative ATCF	-5,12,000	-3,12,000	-1,02,000	78,000	2,58,000

As you can see, in year 3, the cumulative cash flow sign changes from negative to positive, meaning that at some point between year 2 and 3, costs would be recovered by generated profit.So, the payback period is somewhere in year 2.To calculate the fraction, we can simply divide the 1,02,000 (cumulative cash flow in year 2) by 1,80,000(cash flow in year 3). Therefore the payback period equals: 2+1,02,000/1,80,000= 2.56 years.

B.NET PRESENT VALUE :

To Calculate NPV We have to know the Discounting Rate, Here Discounting Rate Will be Weighted Average Cost of Capital(WACC)

WACC = (Cost of debt)*Debt proportion/total proportion + (Cost of Pref shares)*Pref proportion/total proportion + (Cost of Equity Shares)*Equity proportion/total proportion

WACC = 0.12504*3/10+0.33*3/10+0.13*3/10 = 17.55%

NPV FOR PRODUCT A

cash outflows on year 0 = $ 7,60,000

Discounted cash inflows of 5 years on year 0 = 3,20,000*1/1.1755+3,00,000*1/(1.1755)(1.1755)+....so on till 5 years

   = $ 8,98,246

NPV = 8,98,246-7,60,000 = $ 1,38,246 /-

NPV FOR PRODUCT B

cash outflows on year 0 = $ 6,50,000

Discounted cash inflows of 5 years on year 0 = 2,00,000*1/1.1755+2,40,000*1/(1.1755)(1.1755)+... so on till 5 years

= $ 7,05,000

NPV = 7,05,000-6,50,000 = $ 55,000/-

NPV FOR PRODUCT C

cash outflows on year 0 = $ 5,12,000

Discounted cash inflows of 4 years on year 0 = 2,00,000*1/1.1755+2,10,000*1/(1.1755)(1.1755)+..... so on till year 4

= $ 5,27,204

NPV = 5,27,204-5,12,000 = $ 15,204/-

C.PROFITABILITY INDEX :

PI = PV of Future Cash Inflows/Initial Investment

PI for Product A = 8,98,246/7,60,000 = 1.182

PI for Product B = 7,05,000/6,50,000 = 1.084

PI for Product C = 5,27,204/5,12,000 = 1.029

D. PROJECT SELECTION DECISION :

All the Produts are having PI More than 1, means all are acceptable if we look by way of PI Measure

All the Products are having Positive NPV, hence all are acceptable but product with high NPV is Prefered. That is Product A having highest Npv of 1,38,246 is Prefered.

And as per Payback period Method, Product A has less Payback Period when compared to others.

Therefore, Project A is to be Selected.