The conference on evaluating capital projects has been very helpful. You have re
ID: 2652923 • Letter: T
Question
The conference on evaluating capital projects has been very helpful. You have received a significant amount of information and multiple projects to evaluate to hone your skills. To adequately teach Grammy and the board you will need to answer several questions about the capital-budgeting process. You will do this in a business memo that is no more than four pages long.
Provide an evaluation of two proposed project, both with a 5-year expected lives and identical initial outlays of $110,000. Both of these projects involve additions to a highly successful product line, and as a result, the required rate of return on both projects has been established at 12 percent. The expected free cash flows from each project are as follows:
Project A
Project B
Initial outlay
-$110,000
-$110,000
Inflow year 1
20,000
40,000
Inflow year 2
30,000
40,000
Inflow year 3
40,000
40,000
Inflow year 4
50,000
40,000
Inflow year 5
70,000
40,000
In evaluating these projects, please respond to the following question:
Why is the capital-budgeting process so important?
Why is it difficult to find exceptionally profitable projects?
What is the payback period on each project? If the organization imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?
What are the criticisms of the payback period?
Determine the NPV for each of these projects. Should they be accepted?
Describe the logic behind the NPV.
Determine the PI for each of these projects. Should they be accepted?
Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
What would happen to the NPV and PI for each project if the required rate of return increased? If the required rate of return decreased?
Determine the IRR for each project. Should they be accepted?
How does a change in the required rate of return affect the project’s internal rate of return?
What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?
Project A
Project B
Initial outlay
-$110,000
-$110,000
Inflow year 1
20,000
40,000
Inflow year 2
30,000
40,000
Inflow year 3
40,000
40,000
Inflow year 4
50,000
40,000
Inflow year 5
70,000
40,000
Explanation / Answer
Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are that the business will have little chance of surviving in the competitive marketplace.
To be "exceptionally" profitable, would indicate that the profit potential is clear, obvious, and certain. And as such, you may be sure that millions like you will see it.
And as many of them have the investment capital to jump in, you are left behind. Or, even if you have capital, too, the volume of people trying to start the project decreases the profits.
Which is why there are so few "exceptional" profits.
Try for a "good", or even a "modest" profit. Trust me, a "modest" profit is better than most people get.
Payback Period
Investment in Project A & B each = $110000
Payback period of Project A = 3 Years + (110000-90000)/((140000-90000)
= 3.60 Years
Payback Period of Project B = 2 Years + + (110000-80000)/(120000-80000)
= 2.75 Years
If the organization imposes a 3-year maximum acceptable payback period, project B should be accepted.
CRITICISM OF PAYBACK PERIOD
The basic criticisms of the payback period method are that it does not measure the profitability of an investment and it does not consider the time value of money.
NPV
Projects have a positive NPV. So they should be accepted.
Cash Flows Project A Cumulative Project B Cumulative Year 1 20000 20000 40000 40000 Year 2 30000 50000 40000 80000 Year 3 40000 90000 40000 120000 Year 4 50000 140000 40000 160000 Year 5 70000 210000 40000 200000Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.