Your first assignment in your new position as assistant financial analyst at Cal
ID: 2716799 • 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.
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
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 questions:
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 Caledonia imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?
What are the criticisms of the payback period?
What is the discounted payback period of each project? Should they be accepted if 3-year maximum is imposed?
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?
Determine the IRR for each project. Should they be accepted?
What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?
Determine the MIRR for each project. Should they be accepted?
What is the difference between MIRR and IRR and which one is better?
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
Explanation / Answer
(‘1) Importance of Capital Budgeting Process-
Long Term Decision-Capital budgeting is the evaluation and selection of long term investments. As these are the decisions taken for long term investments hence affect the company’s over several coming years.
Huge Fixed Cost-This decision involves huge fixed cost which will be recovered gradually over the life of projects.
Funds invested for long term purpose. Hence proper evaluation is necessary before such decisions.
Irreversible Nature- As large amount and large time span involves in such decision hence these decisions are reversible.
(‘2) As huge fixed cost are invested in capital budgeting investment. Decision also affects projects revenue over the several coming years. As time span is very large hence it is very complex process to evaluate such projects. Due to high amount and larger recovery period of capital invested, it is very hard to find the investor for such investments.
So lack of availability of investor is the main reason to find the exceptionally profitable projects.
Apart from this larger time period involved higher financial risk, inflation risk and technical obsolescence risk is also affect the availability of projects.
(‘3) Payback period and discounted payback period-
Project A
Year
Cash Inflow
Cumulative Cash Inflow
PVF @ 12 %
Discounted Cash Flow
Cumulative Discounted Cash Flow
1
20,000
20,000
0.893
17,857
17,857
2
30,000
50,000
0.797
23,916
41,773
3
40,000
90,000
0.712
28,471
70,244
4
50,000
140,000
0.636
31,776
102,020
5
70,000
210,000
0.567
39,720
141,740
141,740
As cumulative cash flow cross the initial investment in the year 4 hence payback period will be in the year 4,
Payback Period = 3 years + (110000-90000)/(140000-90,000)
Payback period = 3.40 years
Discounted Payabck Period = 4 years + ( 110000-102020)/(141740-102020)
Discounted payback period = 4 + (0.2 year)
Discounted payback period = 4.2 years.
Project B
Year
Cash Inflow
PVF @ 12 %
Discounted Cash Flow
Cumulative Discounted Cash Flow
1
40,000
0.893
35,714
35,714
2
40,000
0.797
31,888
67,602
3
40,000
0.712
28,471
96,073
4
40,000
0.636
25,421
121,494
5
40,000
0.567
22,697
144,191
144,191
Payback period = Initial Investment/ Yearly Cash Inflow
Payback period = 110,000/40,000
Payback period = 2.75 years
Discounted Payback period = 3 year + ( 110000-96073)/ (121494-96073)
Discounted payback period = 3 + (0.55 years)
Discounted payback period = 3.55 Years.
Acceptance of projects based on payback period- Project B should be accepted as its payback period is less than maximum accepted period of 3 years.
Project A should not be accepted as its payback is higher than 3 years.
Acceptance of projects based on discounted payback period-
No projects should be accepted as both projects discounted payback is more than 3 years.
(‘4) NPV-
Particulars
Project A
Project B
Present Value of Cash Inflow (a)
141,740
144,191
Initial Investment (b)
110,000
110,000
NPV (a-b)
31,740
34,191
Decision- Based on higher NPV project B should be accepted.
(‘5) PI-
PI = Present Value of Cash Inflows/ Initial Investment
Project A = 141740/110000
Project A = 1.29
Project B = 1.31
Year
Cash Inflow
Cumulative Cash Inflow
PVF @ 12 %
Discounted Cash Flow
Cumulative Discounted Cash Flow
1
20,000
20,000
0.893
17,857
17,857
2
30,000
50,000
0.797
23,916
41,773
3
40,000
90,000
0.712
28,471
70,244
4
50,000
140,000
0.636
31,776
102,020
5
70,000
210,000
0.567
39,720
141,740
141,740
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