You recently went to work for Allied Components Company, a supplier of auto repa

Question

You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market. Your supervisor just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm?s ignition systems line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have three year lives The company believes the risks of the two projects are comparable. Here are the projects? after-tax cash flows (in thousands of dollars): The company?s Weighted Average Cost of Capital s 10%. You must determine whether one or both of the projects should be accepted. 1. Calculate each project?s Net Present Value (N PV). 2. Based on the NPVs, which project(s) should be chosen if the projects are independent? If they are mutually exclusive? 3. Calculate each projects Profitability Index (Pl). 4. Based on the PIs, which project(s) should be chosen if the projects are independent? If they are mutually exclusive? 5. Calculate each project?s Internal Rate of Return (IRR). 6. Based on the lRRs, which project(s) should be chosen if the projects are independent? If they are mutually exclusive? 7. Calculate each project?s payback period. 8. The company?s maximum acceptable payback period is two years. Based on this maximum payback and the computed payback periods, which project(s) should be chosen if the projects are independent? If they are mutually exclusive?

Explanation / Answer

1)

Project L

NPV = -Initial Investment + CF1/(1+WACC) +  CF2/(1+WACC)^2 +  CF3/(1+WACC)^3  +  CF4/(1+WACC)^4

NPV = -100 + 10/1.10 + 60/1.1^2 + 80/1.1^3

NPV = $ 18.78

Project S

NPV = -Initial Investment + CF1/(1+WACC) +  CF2/(1+WACC)^2 +  CF3/(1+WACC)^3  +  CF4/(1+WACC)^4

NPV = -100 + 70/1.10 + 50/1.1^2 + 20/1.1^3

NPV = $ 19.98

2)

Based on NPV , if the project are independent

Both Project Should be selected, as both NPV are positive

Based on NPV , if the project are mutual exclusive

Project S Should be selected, as its NPV is higher

3)

Project L

Profitable Index = 1+ NPV/Initial Investment

Profitable Index = 1 + 18.78/100

Profitable Index = 1.19

Project S

Profitable Index = 1+ NPV/Initial Investment

Profitable Index = 1 + 19.98/100

Profitable Index = 1.20

4)

Based on PI , if the project are independent

Both Project Should be selected, as both PI are greater than 1

Based on PI , if the project are mutual exclusive

Project S Should be selected, as its PI is higher

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