Your first assignment in your new position as assistant financial analyst at Cal
ID: 2715265 • Letter: Y
Question
Your first assignment in your new position as assistant financial analyst at Caledonia Products is to evaluate two new capital-budgeting proposals. Because this is your first assignment, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at assessing your understanding of the capital-budgeting process. This is a standard procedure for all new financial
analysts at Caledonia, and it will serve to determine whether you are moved directly into the capital-budgeting analysis department or are provided with remedial training. The memorandum you received outlining your assignment follows:
To: The New Financial Analysts
From: Mr. V. Morrison, CEO, Caledonia Products
Re: Capital-Budgeting Analysis
Provide an evaluation of two proposed projects, both with 5-year expected lives and identical initial outlays of $110,000. Both of these projects involve additions to Caledonia’s highly successful Avalon 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 45,000
Inflow year 2 30,000 45,000
Inflow year 3 40,000 45,000
Inflow year 4 50,000 45,000
Inflow year 5 70,000 45,000
Caledonia is considering two additional mutually exclusive projects. The free cash flows associated with these projects are as follows:
PROJECT A PROJECT B
Initial outlay -$100,000 -$100,000
Inflow year 1 32,000 0
Inflow year 2 32,000 0
Inflow year 3 32,000 0
Inflow year 4 32,000 0
Inflow year 5 32,000 200,000
The required rate of return on these projects is 11 percent.
1. What is each project’s payback period?
2. What is each project’s NPV?
3. What is each project’s IRR?
4. What has caused the ranking conflict?
5. Which project should be accepted? Why?
Must show calculations or steps in excel
Explanation / Answer
Payback period Ranking NPV Ranking IRR Ranking Project A 3.42 years 3 31739.95 2 21% 2 Project B 2.5 years 1 52214.93 1 30% 1 Project C 3.2 years 2 18268.70 4 18% 3 Project D 5 years 4 18690.27 3 15% 4 Decision based on ranking Payback period Accept Project B Net Present Value Accept Project B Internal Rate of return Accept Project B Hence the overall decision is to accept Project B over other projects A look at the other projects show that there is a conflict in decisions between payback period, net present value and IRR - payback period does not capture the full term of the cash flows. Hence projects with higher cash flows towards the end of the project life (like project D) will have a longer payback period - NPV is depedant on the discount rate. A higher discount rate will understate a positve NPV and overstate a negative NPV in this case Project A and B were discounted at 12% while projects C and D were discounted at 11% - internal rate of return (IRR) is the internal rate of return at which the NPV is equal to zero and hence is not dependant on discount rates like NPV. However, any abnormal cash flows like intermediate negative flows or abnormal cash flows at the end of the project (like project D) will affect the IRR calculation. Generally level cash flows throughout the project life with an initial negative flow will give a correct picture of IRR compared to projects with abnormal intermediate flows. Project A Year 0 1 2 3 4 5 cash flows -110000 20000 30000 40000 50000 70000 Discount rate 12% Discount Factor 1 0.89285714 0.797194 0.71178 0.635518 0.567427 Discounted flows -110000 17857.1429 23915.82 28471.21 31775.9 39719.88 Net Present Value =sum of discounted cash flows = 31739.95 Internal Rate of return (IRR) = IRR function of Excel the range of cash flows from year zero to year 5 = 21% Net Negative Flow -90000 -60000 -20000 0 Net negative flow is equal to -initial flow+cash flows in years 1-5 for the year. This is calculated till net negative flow is zero Payback period 3 years + (20000/50000)*12 = 3 years +4.8 months or 3.42 years Project B Year 0 1 2 3 4 5 cash flows -110000 45000 45000 45000 45000 45000 Discount rate 12% Discount Factor 1 0.89285714 0.797194 0.71178 0.635518 0.567427 Discounted flows -110000 40178.5714 35873.72 32030.11 28598.31 25534.21 Net Present Value =sum of discounted cash flows = 52214.93 Internal Rate of return (IRR) = IRR function of Excel the range of cash flows from year zero to year 5 = 30% Net Negative Flow -65000 -20000 0 Net negative flow is equal to -initial flow+cash flows in years 1-5 for the year. This is calculated till net negative flow is zero Payback period 2 years + (20000/45000)*12 = 2 years +5.33 months or 2.5 years Project C Year 0 1 2 3 4 5 cash flows -100000 32000 32000 32000 32000 32000 Discount rate 11% Discount Factor 1 0.9009009 0.811622 0.731191 0.658731 0.593451 Discounted flows -100000 28828.8288 25971.92 23398.12 21079.39 18990.44 Net Present Value =sum of discounted cash flows = 18268.7 Internal Rate of return (IRR) = IRR function of Excel the range of cash flows from year zero to year 5 = 18% Net Negative Flow -68000 -36000 -4000 0 Net negative flow is equal to -initial flow+cash flows in years 1-5 for the year. This is calculated till net negative flow is zero Payback period 3 years + (4000/32000) = 3 years +0.125 or 3.2 years Project D Year 0 1 2 3 4 5 cash flows -100000 0 0 0 0 200000 Discount rate 11% Discount Factor 1 0.9009009 0.811622 0.731191 0.658731 0.593451 Discounted flows -100000 0 0 0 0 118690.3 Net Present Value =sum of discounted cash flows = 18690.27 Internal Rate of return (IRR) = IRR function of Excel the range of cash flows from year zero to year 5 = 15% Net Negative Flow -100000 -100000 -100000 -100000 0 Net negative flow is equal to -initial flow+cash flows in years 1-5 for the year. This is calculated till net negative flow is zero Payback period 5 years
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