Capital Budgeting – Two Investment Proposals As you know, we have experienced ra

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Capital Budgeting – Two Investment Proposals

As you know, we have experienced rapid growth in the last few years. As a result, we have been able to consistently pay dividends to our shareholders. The average annual rate of return on the stock in the last few years has been 20% which is equivalent to our cost of capital.

To focus on sustaining our growth for the future, Nancy Johnson recommends that the firm continue to invest in projects that offer the highest return possible.

With that, two projects are being proposed for review. Sue Sullivan has brought forth a project to expand the firm’s production capacity. Mary Mason brought forth a project to introduce one of our top-line snack goods to a new market. The initial investments and projected cash flows are shown below.

Can you please calculate the payback period, NPV, IRR, and PI to measure the value of these projects? In addition, can you please rank the projects according to each criterion? If there are conflicts in ranking, please provide an explanation as to why.

I know that you will be receiving a memo from Nancy Johnson shortly concerning these two proposed projects. Therefore, I want to be able to have your financial analysis ahead of time to review.   

                                                                        Plant                           Product            

          Expansion Introduction

Initial Investment

$(3,500,000)

$(500,000)

Cash inflows:

Year 1

1,500,000

250,000

Year 2

2,000,000

350,000

Year 3

2,500,000

375,000

Year 4

2,750,000

425,000

Initial Investment

$(3,500,000)

$(500,000)

Cash inflows:

Year 1

1,500,000

250,000

Year 2

2,000,000

350,000

Year 3

2,500,000

375,000

Year 4

2,750,000

425,000

Explanation / Answer

Payback Period is the no. of years it takes to recover intial investment. As introduction has lower payback period, we select this project.

NPV and IRR can be calculated using the same function on a financial calculator. Select expansion in NPV criteria as its NPV is greater than introduction. Select introduction based on IRR criteria as it has higher IRR.

PI = 1 + NPV / Initial Investment. Select introduction as it has higher PI.

Year Expansion Introduction 0 -3,500,000 -500,000 1 1,500,000 250,000 2 2,000,000 350,000 3 2,500,000 375,000 4 2,750,000 425,000 Payback 2.00 1.71 NPV $1,911,844 $373,360 IRR 43.70% 52.33% PI 1.55 1.75

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