It's been two months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recommendation, but also to respond to a number of questions aimed at judging your understanding of the capital-budgeting process. The memorandum you received outlining your assignment follows:
TO: The Assistant Financial Analyst
FROM: Mr. V. Morrison, CEO, Caledonia Products
RE: Cash Flow Analysis and Capital Rationing
12. Caledonia is considering two additional mutually exclusive projects. The cash flows associated with these projects are as follows:
YEAR PROJECT A PROJECT B
0 -$100,000 -$100,000
1 32,000 0
2 32,000 0
3 32,000 0
4 32,000 0
5 32,000 $200,000
The required rate of return on these projects is 11 percent. (Keown, Martin, Petty, & Scott, 2005, chapter 10 p. 1)
What is each project's payback period?
What is each project's net present value?
What is each project's internal rate of return?
What has caused the ranking conflict?
Which project should be accepted? Why?
Please see the attached file
a. What is each project's payback period?
Payback period is the time taken to recover the initial investment.
Project A - The initial investment is $100,000. In 3 years we recover 32,000X3=96,000. The remaining amount is 100,000-96,000=4,000. This is recovered in year 4. The part of year 4 needed to recover 4,000 is 4,000/32,000=0.125. The payback period is 3.125 years.
Project B - The initial investment is $100,000. There is no recovery till year 4. In year 5 we get $200,000 so ½ of year 5 is needed to recover $100,000. The total payback period is 4.5 years
b. What is each project's net present value?
The solution explains the calculation of payback period, net present value, internal rate of return for each project and make the acceptance/rejection decision.