Question

Mini Case This Mini Case is available in MyFinanceLab. 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 memo- randum you received outlining your assignment follows: To: The 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 $110,000. 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 12 percent. The expected free cash flows from each project are as follows: PROJECT B PROJECT A -$110,000 -$110,000 Initial outlay 40,000 20,000 Inflow year 1 40,000 Inflow year 2 30,000 Inflow year 3 40,000 40,000 Inflow year 4 40,000 50,000 Inflow year 5 70,000 40,000 You have also been asked for your views on three unrelated sets of projects. Each set of projects made by the NPV and IRR methods? involves two mutually exclusive projects. These projects follow. Caledonia is considering is the better and will produce two investments with 1-year lives. The more expensive of the two more savings. Assume these proiects are mutually exclusive m. and that the required rate of return is 10 percent. Given the following free cash flows: PROJECT A PROJECT B Initial outlay -$195,000 -$1,200,000 Inflow year 1 240,000 1,650,000 1. Calculate the NPV for each project. 2. Calculate the PI for each project. 3. Calculate the IRR for each project. 4. If there is no capital-rationing constraint, which project should be selected? If there is a capital-rationing constraint, how should the decision be made? Caledonia is considering associated with these projects two additional mutually exclusive projects. The free cash flows are as follows: n. PROJECT B PROJECT A -$100,000 -$100,000 Initial outlay 0 32,000 Inflow year 1 0 32,000 Inflow year 2 32,000 Inflow year 3 0 32,000 Inflow year 4 200,000 32,000 Inflow year 5 The required 1. What is each project's payback period? 2. What is each project's NPV? 3. What is each project's IRR? 4. What has caused the ranking conflict? 5. Which project should be accepted? Why? rate of return on these projects is 11 percent.

Answer 1

		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=Required Return =12%=0.12
		N=Year of Cash Flow
		ANALYSIS OF PROJECT A
	N	Year	0	1	2	3	4	5
	CF	Cash Flow	($110,000)	$20,000	$30,000	$40,000	$50,000	$70,000	SUM
	PV=CF/(1.12^N)	Present Value (PV) of Cash Flow:	($110,000)	$        17,857	$    23,916	$ 28,471	$ 31,776	$    39,720	$31,740
	NPV=Sum of PV	Net Present Value (NPV)	$31,740
		Internal Rate of Return (IRR)	21%	(Using IRR function of excel over the cash flow)
		Profitabilty Index(PI)=(NPV+InitialOutlay)/InitialOutlay
		Profitabilty Index(PI)=	1.29	(31740+110000)/110000
		ANALYSIS OF PROJECT B
	N	Year	0	1	2	3	4	5
	CF	Cash Flow	($110,000)	$40,000	$40,000	$40,000	$40,000	$40,000	SUM
	PV=CF/(1.12^N)	Present Value (PV) of Cash Flow:	($110,000)	$        35,714	$    31,888	$ 28,471	$ 25,421	$    22,697	$34,191
	NPV=Sum of PV	Net Present Value (NPV)	$34,191
		Internal Rate of Return (IRR)	24%	(Using IRR function of excel over the cash flow)
		Profitabilty Index(PI)=(NPV+InitialOutlay)/InitialOutlay
		Profitabilty Index(PI)=	1.31	(34191+110000)/110000
		PROJECT B SHOULD BE SELECTED
	m	DISCOUNT RATE=10%=0.1
		ANALYSIS OF PROJECT A
	N	Year	0	1
	CF	Cash Flow	($195,000)	$240,000	SUM
	PV=CF/(1.1^N)	Present Value (PV) of Cash Flow:	($195,000)	$     218,182	$    23,182
	NPV=Sum of PV	Net Present Value (NPV)	$        23,182
		Internal Rate of Return (IRR)	23%	(Using IRR function of excel over the cash flow)
		Profitabilty Index(PI)=(NPV+InitialOutlay)/InitialOutlay
		Profitabilty Index(PI)=	1.12	(23182+195000)/195000
		ANALYSIS OF PROJECT B
	N	Year	0	1
	CF	Cash Flow	($1,200,000)	$1,650,000	SUM
	PV=CF/(1.1^N)	Present Value (PV) of Cash Flow:	($1,200,000)	$ 1,500,000	$ 300,000
	NPV=Sum of PV	Net Present Value (NPV)	$     300,000
		Internal Rate of Return (IRR)	37%	(Using IRR function of excel over the cash flow)
		Profitabilty Index(PI)=(NPV+InitialOutlay)/InitialOutlay
		Profitabilty Index(PI)=	1.25	(300000+1200000)/1200000
		PROJECT B SHOULD BE SELECTED
		Discount Rate-11% 0.11 ANALYSIS OF PROJECTA N Year 0 1 2 3 4 5 ($100,000) ($100,000) $ $18,269 $32,000 $32,000 $32,000 $32,000 $32,000 SUM Cash Flow CF PV=CF/(1.11N) Present Value (PV) of Cash Flow: 28,829 25,972 $23,398$21,079 18,990 $18,269 NPV-Sum of PV Net Present Value (NPV) Internal Rate of Return (IRR) 18% (Using IRR function of excel overthe cash flow) Profitabilty Index(PI)=(NPV+HInitial outlay)/InitialOutlay Profitabilty Index(Pl)= 1.18 (18269+100000)/110000 ANALYSIS OF PROJECT B N Year 0 1 4 ($100,000) ($100,000) $18,690 $0 $0 $0 $0 $200,000 SUM Cash Flow CF PV=CF/(1.11N) Present Value (PV) of Cash Flow: NPV Sum of PV Net Present Value (NPV) Internal Rate of Return (IRR) $118,690 $18,690 15% (Using IRR function of excel over the cash flow) Profitabilty Index(PI)=(NPV+InitialOutlay)/Initial Outlay Profitabilty Index(Pl)= 1.19 (18690+100000)/100000 PROJECT B SHOULD BE SELECTED Though IRR is higher for Project A, Project B should be selected because NPV and Pl are higher NPV indicates generation of shareholders wealth