CASE STUDY: Ashworth Textiles

Your manager, the chief financial officer (CFO) for Ashworth Textiles, has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm's fabric 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 three-year lives because Ashworth is planning to introduce an entirely new fabric at that time.

The following are the net cash flow estimates (in thousands of euros

Expected Net Cash flows

Year

Project L

Project S

0

(100)

(100)

1

10

70

2

60

50

3

80

20

The CFO also made subjective risk assessments of each project, and he concluded that the projects both have risk characteristics that are similar to the firm's average project. Ashworth's required rate of return is 10 percent. You must now determine whether one or both of the projects should be accepted.

REQUIRED:

A. What is capital budgeting?

B. What is the difference between independent and mutually exclusive projects?

C. (1) What is the payback period? Find the traditional (simple) payback periods for Project L and Project S.

(2) According to the payback criterion, which project or projects should be accepted if the firm's maximum acceptable payback is two years and Project L and Project S are independent? Mutually exclusive?

(3) What is the difference between the traditional payback and the dis-counted payback? What is each project's discounted payback?

D. (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 NW, which project or projects should be accepted if they are independent? Mutually exclusive?

(3) Would the NPVs change if the required rate of return changed?

E. (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) According to IRR, which projects should be accepted if they are independent? Mutually exclusive?

(4) Would the projects' IRRs change if the required rate of return changed? Explain.

F. (1) Construct the NPV profiles for Project L and Project S. At what discount rate do the profiles cross?

(2) Which project or projects should be accepted if they are independent? Mutually exclusive? Explain.

G. (1) What is the underlying cause of ranking conflicts between NPV and IRR?

(2) Which capital budgeting method should be used when NPV and IRR give conflicting rankings? Why?