Question

Question 2 (34 Marks) To start your career development immediately after your BBA undergraduate graduation, your first job is employed as an Assistant Financial Analyst at the Avon Cosmetic Products where you are responsible to evaluate capital budgeting proposals. You have been asked not only to provide recommendations, but also to respond to a number of questions aimed for judging your understanding of the capital budgeting process. This is a standard employment procedure for all the new financial analysts being hired for determining whether you can be admitted directly into the capital budgeting analysis department or are provided with remedial trainings. An outline of your assignment is listed below: You are required to provide an evaluation of two proposed projects, Projects A and B, both have five-year project duration and identical initial investment of S110,000 (the whole amount is for acquiring equipment without involving any set up cost). Both of these projects related to the improvement to Avon's highly successful product lines, and as a result, the required rate of return on both projects with similar characteristics has been established at 12 percent (i.e. the company's WACC). The expected free cash flows from each project are listed as follows: Project A Project B Initial investment -$110,000 -$110,000 Year 1 20,000 40,000 Year 2 30,000 40,000 Year 3 40,000 40,000 Year 4 50,000 40,000 Year 5 70,000 40,000 Besides cash flow forecast, the accounting department also prepared a pro-forma income report for these projects. As the residual value of these projects will become zero at the end of project life, using the straight-line depreciation method, the accounting profits for these projects are as follows: Project A (S) Project B (5) Year 1 (2,000) 18,000 Year 2 8,000 18,000 Year 3 18,000 18,000 Year 4 28,000 18,000 Year 5 48,000 18,000

Answer 1

a]	NPV of the two projects are calculated below:
	Project A:
	Year	Cash Flow	PVIF at 12%	PV at 12%
	0	$      -1,10,000	1.00000	$   -1,10,000.00
	1	$           20,000	0.89286	$        17,857.14
	2	$           30,000	0.79719	$        23,915.82
	3	$           40,000	0.71178	$        28,471.21
	4	$           50,000	0.63552	$        31,775.90
	5	$           70,000	0.56743	$        39,719.88
	NPV			$        31,739.95
	Project B:
	Year	Cash Flow	PVIF at 12%	PV at 12%
	0	$      -1,10,000	1.00000	$   -1,10,000.00
	1	$           40,000	0.89286	$        35,714.29
	2	$           40,000	0.79719	$        31,887.76
	3	$           40,000	0.71178	$        28,471.21
	4	$           40,000	0.63552	$        25,420.72
	5	$           40,000	0.56743	$        22,697.07
	NPV			$        34,191.05
	Average rate of return:
	Project A:
	Average annual income = (-2000+8000+18000+28000+48000)/5 =						$     20,000.00
	Average rate of return = Average annual income/Investment = 20000/110000 =						18.18%
	Project B:
	Average rate of return = 18000/110000 =						16.36%
	RECOMMENDATION:
	Per NPV, both the projects are acceptable, as they have positive NPVs.
	Per ARR, also both the projects are acceptable as their ARRs are greater than the required
	return of 12% [assuming required return = WACC].
	But if the projects are mutually exclusive,
	Per NPV, Project B with higher NPV is to be selected and per ARR, Project A with higher
	ARR is to be selected.
	But, since NPV is more reliable for the following reasons, it should be used to rank the
	*NPV considers time value of money
	*It is based on cash flows
	*It can consider risk of the individual projects
	*It gives the direct addtion to shareholders' wealth.
b]	Projects A & B are in the same line of business and hence the 12% WACC can be used for discounting.
	But, as the project is in an entirely new are, the risk would be different and hence the existing WACC
	should not be used for discounting. The WACC needs to be adjusted to represent the risk of the new line
	of business.	If, the existing WACC is used for discounting entirely new business ventures

, it will result in accepting projects that are to be rejected and rejecting projects that are to be accepted.

Projects with higher risk are to be assigned higher required rate of return and projects with lower risk

are to be assigned lower required rate or return.