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 a​result, 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.