Your first assignment in your new position as assistant financial analyst at Cal

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 $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 at 11 percent. The expected free cash flows from each project are shown in the popup window: In evaluating these projects, please respond to the following questions: cash outlays at the beginning of a. The capital-budgeting process is so important because capital-budgeting decisions involve investments requiring rather the life of the project and commit the firm to a particular course of action over a relatively V time horizon. (Sele wn menus.) small moderate large b. Why is it difficult to find exceptionally profitable projects? (Select the best choice below.) O A. There is no reliable method to accurately estimate a project's future cash flows.

Explanation / Answer

a)

Large

b)

Longer time

c)

The existence of competition may drive prices and profit down quickly

d)

Project A:

Cumulative cash flow for year 0 = -110,000

Cumulative cash flow for year 1 = -110,000 + 30,000 = -80,000

Cumulative cash flow for year 2 = -80,000 + 40,000 = -40,000

Cumulative cash flow for year 3 = -40,000 + 30,000 = -10,000

Cumulative cash flow for year 4 = -10,000 + 50,000 = 40,000

10,000 / 50,000 = 0.2

Payback period for project A = 3 + 0.2 = 3.2 years

Reject, greater

e)

Payback of project B = 110,000 / 40,000

Payback of project B = 2.75

accept, less than or equal to

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