The conference on evaluating capital projects has been very helpful. You have received a significant amount of information and multiple projects to evaluate to hone your skills. To adequately teach Grammy and the board you will need to answer several questions about the capital-budgeting process. You will do this in a business memo that is no more than four pages long.
Provide an evaluation of two proposed project, both with a 5-year expected lives and identical initial outlays of $110,000. Both of these projects involve additions to a highly successful product 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:
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Project A
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Project B
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Initial outlay
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-$110,000
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-$110,000
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Inflow year 1
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20,000
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40,000
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Inflow year 2
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30,000
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40,000
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Inflow year 3
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40,000
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40,000
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Inflow year 4
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50,000
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40,000
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Inflow year 5
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70,000
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40,000
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In evaluating these projects, please respond to the following question:
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 the organization 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 be accepted?
Describe the logic 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?