Michael Wright graduated from the University College in June and has been working for about a month as a junior financial analyst at Caledonia Products Ltd. When Michael arrived at work on Monday morning, he found the following memo in his e-mail.

TO: Michael Wright

FROM: V. Morrison, CFO, Caledonia Products Ltd.

RE: Capital Budgeting Analysis

Provide an evaluation of the three proposed projects whose cash flow forecasts are found below:

Product A Product B Product C

Initial cost $760,000 $650,000 $512,000

Expected life 5 years 5 years 4 years

Scrap value expected $30,000 $35,000 $20,000

Expected cash inflows: $ $ $

Year

1 320,000 200,000 200,000

2 300,000 240,000 210,000

3 240,000 210,000 180,000

4 320,000 260,000 160,000

5 180,000 180,000

Since these projects involve additions to Caledonias highly successful Avalon product line, the company uses the WACC of the line to evaluate the additions. The projects are independent.

1. Cost of Debt is 15.63% and the tax rate is 20%;

2. The dividend paid out for preference shares is $6. Each share

currently trades at $21 and has a floatation cost of $3;

3. Ordinary shares receive a dividend of $1.50 per share. It has

growth rate of 10% and it is currently trading at $15 with a

floatation cost of $2.31.

Note:

The Debt : Preference Shares : Ordinary Shares ratio is 3 : 2 : 5

Give me your thoughts on these three projects by 10 am on Wednesday Morning.

Michael was not surprised by the memo, for he had been expecting something like this for some time. Caledonia followed a practice of testing each of their new financial analyst with some type of project evaluation exercise after they have been on the job for a few months. After re-reading the memo, Michael decided on his plan of action and made up the following to do list:

Calculate for each project:

1. The payback period for each project 6 marks
2. The Net Present value (NPV) 10 marks
3. The Profitability Index (PI) 9 marks
4. Which project should be accepted and why? 4 marks

Later that day Michael was approached again by the CFO about the following, which is to be added to the report previously requested:

To absorb some short-term excess production capacity at its plant, the company is considering a short manufacturing run for either of two new products, a temperature sensor or a pressure sensor. The market for each product is known if the products can be successfully developed. However, there is some chance that it will not be possible to successfully develop them. Revenue of $1,000,000 would be realized from selling the temperature sensor and revenue of $400,000 would be realized from selling the pressure sensor. Both amounts are net of production cost but do not include development cost. If development is unsuccessful for a product, then there will be no sales, and the development cost will be totally lost. Development cost would be $100,000 for the temperature sensor and $10,000 for the pressure sensor. The probability that the development of the sensor will be successful is 0.50 for the temperature sensor and 0.80 for the pressure sensor.

1. Construct a decision tree showing all the options available, the revenue and payoff for each option and the probability of success and failure for each option. (11 marks)

Prepare Michaels assignment for his Wednesday meeting with the CFO by filling out your response to the to do list above.