The conference on evaluating capital projects has been very helpful. You have re
ID: 2756245 • 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?
Explanation / Answer
1. Capital budgeting is important because a company commits its resources for a definite period of time as part of company's growth plans and helps to assess the rate of return that the project will generate.It fixes accoutability and measurability and also forewarns the risks involved. It predicts cash flows to occur over the life of the project and hence capital expenditure.Capital budgeting involves assessment of delays,cost overruns and anyother constraints.
2. Competition makes it difficult to find exceptionally profitable projects.Many more entrants to a profitable industry makes the profits decline.
Criticisms 1. It does no take into account returns after the pay-back period.
2. Ignores time-value of money
3.Comparison of two options with unequal lives may not yield accurate results for decision making.
4. A profitable project may be missed if it earns more in later years.
NPV discounts the cash inflows and outflows at the required rate of return ,ie, the cost of capital , and the project that gives greater positive NPV is selected.
Yes, The NPV & PI- both give the same decision-whether to accept or reject projects. The Project's PI will be greater than 1.00 if the NPV is positive and PI will be less than 1.00 if the NPV is negative
Both have positive NPVs Project B has greater NPV and stands first for selection.
As both have IRR >12% COC , both projects can be accepted.
Change in the reqd.rate of return does not affect a project's IRR.
IRR is the rate at which NPV of outflows & inflows is equal to 0.
If the reqd.rate of return is > IRR- project is accepted.
If the reqd.rate of return is < IRR- project is rejected.
Reqd.rate of return is usually the coc - ie. used to discount cash flows.
NPV assumes that cash flows are reinvested at the firm's cost of capital.
IRR assumes that cash flows are reinvested at the IRR.
NPV's assumption is better as, in order to accept a project , the IRR must be greater than the cost of capital
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PROJECT A PROJECT B Year Cash Flows Cumulative Cash Flows Cumulative 0 -110000 -110000 -110000 -110000 1 20000 -90000 40000 -70000 2 30000 -60000 40000 -30000 3 40000 -20000 40000 10000 4 50000 30000 40000 50000 5 70000 100000 40000 90000 Payback period 3 years + 2 years+ 12/50000*20000 12/40000*30000 4.8 9 3 yrs. &5 mths. 2 yrs & 9 mths.Related Questions
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