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) CF 10 70 CF 60 50 CF 80 20 Project Initial Investment 100 100 The company's Weighted Average Cost of Capital is 10%. You must determine whether one or both of the projects should be accepted 1. Calculate each project's Net Present Value (NPV) 2. Based on the NPVs, which project(s) should be chosen if the projects are 3. Calculate each project's Profitability Index (PI) 4. Based on the Pls, which project(s) should be chosen if the projects are independent? If they are mutually exclusive? independent? If they are mutually exclusive? 5. Calculate each project's Internal Rate of Return (IRR) 6. Based on the IRRs, 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. NPV

NPV of L = 18.73

NPV of S = 19.95

2. Based on NPV Project S should be chosen, if the projects are mutually exclusive.

3. PI = Present Value of Cash Inflows / Present Value od Cash Outflows

    Project L = 118.73/100 = 1.1873

    Project S = 119.95/100 = 1.1995

4. Based on PI, Proect S should be chosen if the projects are mutually exclusive.

5. NPV of Project L @ 10% = 18.73

Similarly, NPV of Project L @ 20% -3.71

IRR = Lower rate + NPV at Lower rate / (NPV at Lower rate - NPV at higher rate)

       = 10 + (18.73/(18.73-(-3.71))

       = 10 + (18.73/22.44)

       = 10.83%

NPV of Project S @ 10% = 19.95

NPV of Project S @ 25 = -1.76

IRR = 10 + (19.95/19.95-(-1.76))

       = 10.92%

6. Based on IRR, Project S should be selected if the projects are mutually exclusive.

7. Payback Period of Project L

Payback Period = 2 years + (100-70)/(150-70) = 2.375 years

Payback Period of Project S

Payback Period = 1 year + (100-70)/(120-70) = 1.6 year

8. The company's max allowable payback period is two years. Based on this, Project S should be chosen if the projects are independent & mutually exclusive.

Project Investment CF1 CF2 CF3 L -100 10 60 80 S -100 70 50 20 PVF 1 0.909 0.826 0.751 Amount L -100 9.09 49.56 60.08 Amount S -100 63.63 41.3 15.02

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