BASICS OF CAPITAL BUDGETING You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler AG, Ford, Toyota, 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 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 Allied is planning to introduce entirely new models after 3 years.

Here are the projects after-tax cash flows (in thousands of dollars):

Depreciation, salvage values, net operating 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. Allieds WACC is 10%. You must determine whether one or both of the projects should be accepted.

1. 1. What is the rationale behind the NPV method? According to NPV, which project(s) should be accepted if they are independent? Mutually exclusive?

   2. Would the NPVs change if the WACC changed? Explain.

2. 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 project(s) should be accepted if they are independent? Mutually exclusive?

   4. Would the projects IRRs change if the WACC changed?