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Question: You recently went to work for Allied

You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives because Allied is planning to introduce entirely new models after 3 years. Here are the projects’ net cash flows (in thousands of dollars):
You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives because Allied is planning to introduce entirely new models after 3 years.
Here are the projects’ net cash flows (in thousands of dollars):

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.
The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted.
a. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions?
b. What is the difference between independent and mutually exclusive projects? Between projects with normal and non-normal cash flows?
c. (1) Define the term net present value (NPV). What is each project’s NPV?
(2) What is the rationale behind the NPV method? According to NPV, which project(s) should be accepted if they are independent? mutually exclusive?
(3) Would the NPVs change if the WACC changed? Explain.
d. (1) Define the term internal rate of return (IRR). What is each project’s IRR?
(2) How is the IRR on a project related to the YTM on a bond?
(3) What is the logic behind the IRR method? According to IRR, which project(s) should be accepted if they are independent? mutually exclusive?
(4) Would the projects’ IRRs change if the WACC changed?
e. (1) Draw NPV profiles for Projects L and S. At what discount rate do the profiles cross?
(2) Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which project(s) should be accepted if they are independent? mutually exclusive? Explain. Are your answers correct at any WACC less than 23.6%?
f. (1) What is the underlying cause of ranking conflicts between NPV and IRR?
(2) What is the reinvestment rate assumption, and how does it affect the NPV versus IRR conflict?
(3) Which method is best? Why?
g. (1) Define the term modified IRR (MIRR). Find the MIRRs for Projects L and S.
(2) What are the MIRR’s advantages and disadvantages vis-à-vis the NPV?
h. (1) What is the payback period? Find the paybacks for Projects L and S.
(2) What is the rationale for the payback method? According to the payback criterion, which project(s) should be accepted if the firm’s maximum acceptable payback is 2 years, if Projects L and S are independent, if Projects L and S are mutually exclusive?
(3) What is the difference between the regular and discounted payback methods?
(4) What are the two main disadvantages of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions? Explain.
i. As a separate project (Project P), the firm is considering sponsoring a pavilion at the upcoming World’s Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project P’s expected net cash flows look like this (in millions of dollars):
The project is estimated to be of average risk, so its WACC is 10%.
(1) What is Project P’s NPV? What is its IRR? its MIRR?
(2) Draw Project P’s NPV profile. Does Project P have normal or non normal cash flows? Should this project be accepted? Explain.
Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted. a. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? b. What is the difference between independent and mutually exclusive projects? Between projects with normal and non-normal cash flows? c. (1) Define the term net present value (NPV). What is each project’s NPV? (2) What is the rationale behind the NPV method? According to NPV, which project(s) should be accepted if they are independent? mutually exclusive? (3) Would the NPVs change if the WACC changed? Explain. d. (1) Define the term internal rate of return (IRR). What is each project’s IRR? (2) How is the IRR on a project related to the YTM on a bond? (3) What is the logic behind the IRR method? According to IRR, which project(s) should be accepted if they are independent? mutually exclusive? (4) Would the projects’ IRRs change if the WACC changed? e. (1) Draw NPV profiles for Projects L and S. At what discount rate do the profiles cross? (2) Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which project(s) should be accepted if they are independent? mutually exclusive? Explain. Are your answers correct at any WACC less than 23.6%? f. (1) What is the underlying cause of ranking conflicts between NPV and IRR? (2) What is the reinvestment rate assumption, and how does it affect the NPV versus IRR conflict? (3) Which method is best? Why? g. (1) Define the term modified IRR (MIRR). Find the MIRRs for Projects L and S. (2) What are the MIRR’s advantages and disadvantages vis-à-vis the NPV? h. (1) What is the payback period? Find the paybacks for Projects L and S. (2) What is the rationale for the payback method? According to the payback criterion, which project(s) should be accepted if the firm’s maximum acceptable payback is 2 years, if Projects L and S are independent, if Projects L and S are mutually exclusive? (3) What is the difference between the regular and discounted payback methods? (4) What are the two main disadvantages of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions? Explain. i. As a separate project (Project P), the firm is considering sponsoring a pavilion at the upcoming World’s Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project P’s expected net cash flows look like this (in millions of dollars):
You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives because Allied is planning to introduce entirely new models after 3 years.
Here are the projects’ net cash flows (in thousands of dollars):

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.
The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted.
a. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions?
b. What is the difference between independent and mutually exclusive projects? Between projects with normal and non-normal cash flows?
c. (1) Define the term net present value (NPV). What is each project’s NPV?
(2) What is the rationale behind the NPV method? According to NPV, which project(s) should be accepted if they are independent? mutually exclusive?
(3) Would the NPVs change if the WACC changed? Explain.
d. (1) Define the term internal rate of return (IRR). What is each project’s IRR?
(2) How is the IRR on a project related to the YTM on a bond?
(3) What is the logic behind the IRR method? According to IRR, which project(s) should be accepted if they are independent? mutually exclusive?
(4) Would the projects’ IRRs change if the WACC changed?
e. (1) Draw NPV profiles for Projects L and S. At what discount rate do the profiles cross?
(2) Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which project(s) should be accepted if they are independent? mutually exclusive? Explain. Are your answers correct at any WACC less than 23.6%?
f. (1) What is the underlying cause of ranking conflicts between NPV and IRR?
(2) What is the reinvestment rate assumption, and how does it affect the NPV versus IRR conflict?
(3) Which method is best? Why?
g. (1) Define the term modified IRR (MIRR). Find the MIRRs for Projects L and S.
(2) What are the MIRR’s advantages and disadvantages vis-à-vis the NPV?
h. (1) What is the payback period? Find the paybacks for Projects L and S.
(2) What is the rationale for the payback method? According to the payback criterion, which project(s) should be accepted if the firm’s maximum acceptable payback is 2 years, if Projects L and S are independent, if Projects L and S are mutually exclusive?
(3) What is the difference between the regular and discounted payback methods?
(4) What are the two main disadvantages of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions? Explain.
i. As a separate project (Project P), the firm is considering sponsoring a pavilion at the upcoming World’s Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project P’s expected net cash flows look like this (in millions of dollars):
The project is estimated to be of average risk, so its WACC is 10%.
(1) What is Project P’s NPV? What is its IRR? its MIRR?
(2) Draw Project P’s NPV profile. Does Project P have normal or non normal cash flows? Should this project be accepted? Explain.
The project is estimated to be of average risk, so its WACC is 10%. (1) What is Project P’s NPV? What is its IRR? its MIRR? (2) Draw Project P’s NPV profile. Does Project P have normal or non normal cash flows? Should this project be accepted? Explain.





Transcribed Image Text:

2 + $60 $50 3 -$100 -$100 $10 $70 $80 Project L Project S $20 2 -$0.8 $5.0 -$5.0



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> Why would the inventory turnover ratio be more important for someone analyzing a grocery store chain than an insurance company?

> If a firm’s earnings per share grew from $1 to $2 over a 10-year period, the total growth would be 100%, but the annual growth rate would be less than 10%. True or false? Explain.

> Financial ratio analysis is conducted by three main groups of analysts: credit analysts, stock analysts, and managers. What is the primary emphasis of each group, and how would that emphasis affect the ratios they focus on?

> Indicate the effects of the transactions listed in the following table on total current assets, current ratio, and net income. Use (+) to indicate an increase, (−) to indicate a decrease, and (0) to indicate either no effect or an indet

> Suppose you were comparing a discount merchandiser with a high-end merchandiser. Suppose further that both companies had identical ROEs. If you applied the DuPont equation to both firms, would you expect the three components to be the same for each compa

> Why is it sometimes misleading to compare a company’s financial ratios with those of other firms that operate in the same industry?

> Give some examples that illustrate how (a) Seasonal factors and (b) Different growth rates might distort a comparative ratio analysis. How might these problems be alleviated?

> Is it better for a firm’s actual stock price in the market to be under, over, or equal to its intrinsic value? Would your answer be the same from the standpoints of stockholders in general and a CEO who is about to exercise a million dollars in options a

> If a firm’s ROE is low and management wants to improve it, explain how using more debt might help.

> How does a cost-efficient capital market help reduce the prices of goods and services?

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