Comprehensive Problem Chapter 9    –Caledonia products

You first assignment in your new position as assistant financial analyst at Caledonia products is to evaluate two new capital-budgeting proposals. Because this your first assignment, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at judging your understating of the capital-budgeting process. This 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 memo-random 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 produce 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:

1. Why is the capital-budgeting process so important?
2. Why is it difficult to find exceptionally profitable projects?
3. 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?
4. What are the criticisms of the payback period?
5. Determine the NPV for each of these projects. Should they accepted?
6. Describe the login behind the NPV
7. Determine the PI for each of these projects. Should they be accepted?
8. Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
9. What would happen to the NPV and PI for each project if the required rate of return increased? If the required rate of return decreased?
10. Determine the IRR for each project. Should they be accepted?
11. How does a change in the required rate of return affect the project’s internal rate of return?
12. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better/