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: 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 $130,000. both of these projects involve additions to Caledonia's highly successful Avalon product line, and as aresult, the required rate of return on both projects has been established at 10 percent. The expected free cash flows from each project are shown in the popup window:

PROJECT A PROJECT B

Initial outlay -130,000 -130,000

Inflow year 1 30,000 40,000

Inflow year 2 20,000 40,000

Inflow year 3 30,000 40,000

Inflow year 4 60,000 40,000

Inflow year 5 60,000 40,000

In evaluating these projects, please respond to the following questions:

a. Why is the capital-budgeting process so important?

b. Why is it difficult to find exceptionally profitable projects?

c. What is the payback period on each project? If Caledonia imposes a 4-year maximum acceptable payback period, which of these projects should be accepted?

d. What are the criticisms of the payback period?

e. Determine the NPV for each of these projects. Should either project be accepted?

f. Describe the logic behind the NPV.

g. Determine the PI for each of these projects. Should either project be accepted?

h. Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?

i. 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?

j. Determine the IRR for each project. Should either project be accepted?

k. How does a change in the required rate of return affect the project's internal rate of return?

l. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?

Answer #1

a . Capital Budgeting process is importance because it helps companies make decision on the viability of the projects. Often company can have multiple options to spend capital expenditure, thus choosing the one with the most optimum returns is extremely critical.

Capital Budgeting process helps managers analyze different projects so that they can make balanced decision on which project to go ahead with.

In our example Caledonia Products is analyzing two projects i.e project A and project B, where the initial outlay is 130,000 thus its is critical for us to select the right project has it will impact the financials of Caledonia Products.

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