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Project Management Questions: 3 Year Projects

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Consider the following three-year projects A and B each with the same initial
investment of $1000. You are presented with the following measures for the projects:
Project A: NPV $400; Payback 24 months
Project B: NPV $545; Payback 26 months

Which project would you choose and why?

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The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.

Thus capital budgeting has following characteristics:

The exchange of current funds for future benefits.
The funds are invested in long-term assets.
The future benefits will occur to the firm over a series of years.

Criteria of selection of Capital Budgeting project:

It should maximize the shareholders' wealth.
It should consider all cash flows to determine the true profitability of the project.
It should provide for an objective and unambiguous way of separating good projects from bad ...

Solution Summary

This solution considers three-year projects and explains which project would be the best to choose.

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1. During 1998, the Senbet Discount Tire Company had gross sales of $1 million. The firmâ??s cost of goods sold and selling expenses were $300,000 and $200,000, respectively. These figures do not include depreciation. Senbet also had notes payable of $1 million. These notes carried an interest rate of 10 percent. Depreciation was $100,000. Senbetâ??s tax rate in 1998 was 35 percent.
a. What was Senbetâ??s net operating income?
b. What were the firmâ??s earnings before taxes?
c. What was Senbetâ??s net income?
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2. Consider the following cash flows on two mutually exclusive projects that require an annual return of 15 percent. Working in the financial planning department for the Bahamas Recreation Corp., you are trying to compare different investment criteria to arrive at a sensible choice of these two projects.
Year Fishing Ride Deepwater New Submarine
0 _$600,000 _$1,800,000
1 270,000 1,000,000
2 350,000 700,000
3 300,000 900,000
a. Based on the discounted payback period rule, which project should be chosen?
b. If your decision rule is to accept the project with a greater IRR, which project should you choose?
c. Since you are fully aware of the IRR ruleâ??s scale problem, you calculate the incremental IRR for the cash flows. Based on your computation, which project should you choose?
d. To be prudent, you compute the NPV for both projects. Which project should you choose? Is it consistent with the incremental IRR rule?
3. Calgary Industries, Inc., is considering a new project that costs $25 million. The project will generate after-tax (year-end) cash flows of $7 million for five years. The firm has a debt-to-equity ratio of 0.75. The cost of equity is 15 percent and the cost of debt is 9 percent. The corporate tax rate is 35 percent. It appears that the project has the same risk as that of the overall firm. Should Calgary take on the project?
4. Explain what are the corporationâ??s advantages and disadvantages of the corporation form?

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