Create your own hypothetical capital budgeting project. A) Make up a company (it

Question

Create your own hypothetical capital budgeting project.

A)      Make up a company (it could be real or fictional) and make up/describe a potential project for that company (you should be able to do this in one or two sentences…don’t worry about extreme detail).

B)      Create a cash flow stream for this project (the cash flow stream should be between 4-7 years in length), a critical acceptance level (T), and a required return (k). (Hint: Your cash flows must exceed your initial investment and your critical acceptance level must be less than the length of the project).

C)      Calculate the PP, IRR and NPV for your project

D)     For each decision technique, identify whether or not that technique suggests you should accept or reject the project

E)      Overall, identify whether or not you should accept or reject the project and why. Note that part D is asking for 3 answers (one for each decision technique) while E is just asking for one answer – what is your final recommendation. Also, why doesn’t need to be a long answer, just a few words.

Explanation / Answer

Note: The amount spent on R&D and marketing study is a sunk cost and hence need not be considered.

A) Risky Inc is planning to launch a new product. It has done the R&D and Marketing study for the product at a total cost of $5000. B) The initial outlay is expected to be $10000 for the equipment & $500 for NWC. The project is expected to yield cash inflows after tax of year CFAT 1 3000 2 4000 3 5000 4 4000 5 3600 The life of the project is 5 years after which the salvage value will be zero & the NWC will be realized. The Critical Acceptance Level is 3 years and the MARR = 20% C) Payback period: Cumulative year CFAT CFAT 1 3000 3000 2 4000 7000 3 5000 12000 4 4000 16000 5 3600 19600 Payback period = 2 + (10500-7000)/5000 = 2.7 years. NPV: Initial investment (10000+500) 10500 PV of cash inflows: year CFAT pvif @ 20% PV 1 3000 0.8333 2500 2 4000 0.6944 2778 3 5000 0.5787 2894 4 4000 0.4823 1929 last year CFAT includes release of NWC 5 4100 0.4019 1648 PV of cash inflows 11748 Less: Initial cost 10500 NPV of the project 1248 IRR: year CFAT pvif @ 20% PV pvif @ 25% PV 1 3000 0.8333 2500 0.8000 2400 2 4000 0.6944 2778 0.6400 2560 3 5000 0.5787 2894 0.5120 2560 4 4000 0.4823 1929 0.4096 1638 5 4100 0.4019 1648 0.3277 1343 11748 10502 Since at 25% PV of cash inflows is almost equal to the initial investment of $10500 the IRR can be taken as 25% D) Payback: As the payback of the project of 2.7 years is less that the maximum acceptable payback of three years, the project is acceptable. NPV: As the NPV of the project is positive at $1248, the project can be accepted. IRR: As the IRR of the project of 25% is greater than the MARR of 20% the project can be accepted. E) The project should be accepted as it has a positive NPV. Positive NPV indicates the absolute addition to shareholders' wealth in present value terms if the project is undertaken.

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