Your first assignment in your new position as assistant financial analyst at Cal
ID: 2716078 • Letter: Y
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: 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 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 questions. For questions from (a) to (j) assume that the projects are independent. That is both could be accepted if both are acceptable.
a. What is the payback period on each project? If Caledonia imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?
b. What are the criticisms of the payback period?
c. Determine the NPV for each of these projects. Should they be accepted?
d. Describe the logic behind the NPV.
e. Determine the PI for each of these projects. Should they be accepted?
f. Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
g. Determine the IRR for each project. Should they be accepted?
h. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?
i. Determine the MIRR for each project. Should they be accepted?
j. Describe the logic behind the MIRR.
k. Rank the two project based on all above criteria and make a recommendation as to which (if either) should be
accepted under the assumption that the projects are mutually exclusive.
l. Caledonia is considering two additional mutually exclusive projects. The free cash flows associated with these projects are as follows:
Project A
Project B
Initial outlay
-$100,000
-$100,000
Inflow year 1
32,000
0
Inflow year 2
32,000
0
Inflow year 3
32,000
0
Inflow year 4
32,000
0
Inflow year 5
32,000
200,000
The required rate of return on these projects is 11 percent.
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?
I ONLY NEED TO DO PART l. (the last question) I need to answer questions 1-5
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
Answer: Part I
1. Payback period = Initial investment/after tax annual cash flow
Project A = $100000/$32000
= 3.125Years
Calculation of payback period for project B
In case the annual cas flows are unequal payback period is calculated by adding up the cash flows until the total i s equal to initial cash outlay.
Payback period = 4 + (100000/200000)
= 4.50
2. Calculation of NPV
NPV = P.V of cash inflows - P.V. of cash outflows
Project A = $32000*3.670 - $100000
= $17440
Project B = $200000*0.593 - $100000
= $18600
3. Calculation of I.R.R
IRR = [(P.V. of cash infows - Initial cash outflow)/Initial cash outflow]/100
Project A = [($117440-$100000)/$100000]*100
= 17.44%
Project B = [($118600-$100000)/$100000]*100
= 18.60%
4. If we select payback period method as our base to select the project than we should go for project-A since it has least payback period. However if we select I.R.R method and NPV method as a base than we should go for Profect-B since it has higher I.R.R and also the highr NPV. Now the ranking conflict is that these methods are suggesting selection of both methods, which is not possible since it is mutually exclusive project. Now we have to select only one method as a base to rank these projects.
5. NPV is a most reliable method of selection of a project. therefore we should apply NPV method for selection. Accordingly Project-B should be selected since it has higher NPV.
Time Annual Cash flows Cumulative cash flows 1 0 0 2 0 0 3 0 0 4 0 0 5 200000 200000Related Questions
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