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    Capital Budgeting Metrics

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    Strident Marks is considering purchasing new manufacturing equipment that costs $1,300,000 and is expected to improve cash flows by $500,000 in year 1, $350,000 in year 2, $475,000 in year 3, $450,000 in year 4, and $300,000 in year 5.
    Calculate key financial metrics for this capital budgeting project. Assume a 14% rate of return for the project. These key metrics must include (1) payback period, (2) net present value, (3) internal rate of return and (4) modified rate of return. (Use 6% as the finance rate, and 14% as the reinvest rate.)
    In a memo to the CFO, discuss the metrics and make a recommendation whether to accept or reject the project.

    You are a financial analyst in the finance division of Strident Marks, a manufacturer of athletic equipment and apparel, which has recently gone through the initial public offering (IPO) process and has become a public company. Strident Marks has annual sales revenue of approximately $50 million and makes seven unique and distinct products (which serve seven different markets). Each product is represented by its own division within the company and has its own group of sales, marketing, and manufacturing personnel. Some departments, including human resources and the finance division, support the entire organization. Operations consist of a single headquarters and production (manufacturing) center.
    In your role as financial analyst you are responsible for compiling and reporting on budget / forecast data, for assisting your investor relations department, and for assessing and valuing new business opportunities (which will ultimately be presented to upper management). You report directly to the Chief Financial Officer (CFO) and have the use of the accounting department's staff accountants to assist you with your budget / forecast responsibilities.
    You have been informed by the CFO that Strident Marks will be aggressively pursuing new business opportunities, which may include expansion through acquisition and the development and implementation of new products. As a publicly traded company, Strident Marks is scrutinized by bankers and investors as never before. In fulfilling your responsibilities you must keep this in mind, and you must instill a new sense of financial discipline in the organization.

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    Solution Preview

    The calculation are in the excel file.

    1. Payback Period - In Payback period we get the time it takes to get back the initial investment from the project cash inflows. In this method, no discounting is used and the cash flows are simply added till we get back the initial investment. While not discounting is a drawback, this method is a measure of liquidity, since projects which have lower payback are more liquid. We get back the initial investment faster. Under this method, lower period are better. Payback method is not used in making accept reject decisions since it does not take into account the time value of money. Here the initial investment is 1,300,000. In years 1 and 2 we recover $850,000 and so $450,000 is left. This is recovered in year 3. In year 3, we get a total of 475,000, so the time taken to recover 450,000 is 450,000/475,000=0.95 years. The total payback period is 2.95 ...

    Solution Summary

    The solution explains the capital budgeting metrics of payback period, net present value, internal rate of return and modified internal rate of return.