Alliance Systems Company

Capital Budgeting

You recently went to work for Alliance Systems Company, a supplier of heavy duty machines used in the construction sites. 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 firms 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 Alliance is planning to introduce entirely new models after 3 years.

Here are the projects net cash flows (in thousands of dollars):

0 1 2 3

Project L -100 20 55 75

Project S -100 60 65 15

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 firms average project. Alliances WACC is 10%.

Required:

Write a memo that incorporates A to H below to the CFO. You must determine whether one or both of the projects should be accepted.

A. What is capital budgeting? Are there any similarities between a firms capital budgeting decisions and an individuals investment decisions?

B. What is the difference between independent and mutually exclusive projects? Between projects with normal and nonnormal cash flows?

C. (1) Define the term net present value (NPV). What is each projects 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 projects 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 projects 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 the best? Why?

G. (1) Define the term modified IRR (MIRR). Find the MIRRs for Projects L and S.

(2) What are the MIRRs advantages and disadvantages vis--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 firms 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? What is Project L and Ss discounted payback, assuming a 10% cost of capital?

(4) What are the two main disadvantages of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions? Explain.