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:
- 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?
- Determine the NPV for each of these projects. Should they accepted?
- Describe the login behind the NPV
- Determine the PI for each of these projects. Should they be accepted?
- Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
- 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?
- Determine the IRR for each project. Should they be accepted?
- How does a change in the required rate of return affect the project’s internal rate of return?
- What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better/
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