Question 2 (34 Marks) To start your career development immediately after your BBA undergraduate graduation, your first job is employed as an Assistant Financial Analyst at the Avon Cosmetic Products where you are responsible to evaluate capital budgeting proposals. You have been asked not only to provide recommendations, but also to respond to a number of questions aimed for judging your understanding of the capital budgeting process. This is a standard employment procedure for all the new financial analysts being hired for determining whether you can be admitted directly into the capital budgeting analysis department or are provided with remedial trainings. An outline of your assignment is listed below: You are required to provide an evaluation of two proposed projects, Projects A and B, both have five-year project duration and identical initial investment of $110,000 (the whole amount is for acquiring equipment without involving any set up cost). Both of these projects related to the improvement to Avon's highly successful product lines, and as a result, the required rate of return on both projects with similar characteristics has been established at 12 percent (i.e. the company's WACC). The expected free cash flows from each project are listed as follows: Project A Project B Initial investment -$110,000 -$110,000 Year 1 20,000 40,000 Year 2 30,000 40,000 Year 3 40,000 40,000 Year 4 50,000 40,000 Year 5 70,000 40,000 Besides cash flow forecast, the accounting department also prepared a pro-forma income report for these projects. As the residual value of these projects will become zero at the end of project life, using the straight-line depreciation method, the accounting profits for these projects are as follows: Project A ($) Project B ($) Year 1 (2,000) 18,000 Year 2 8,000 18,000 Year 3 18,000 18,000 Year 4 28,000 18,000 Year 5 48,000 18,000 Required: In evaluating these two projects, you are required to answer the following questions: a) Why is the capital budgeting process so important? Explain why capital budgeting errors can be costly? (within 100 words] (4 marks) b) What is the payback period on each project? If Avon imposes a three-year maximum acceptable payback period, which of these projects should be accepted and rejected? (4 marks) c) What is the average accounting return (AAR) for each project? If the acceptable ARR is 35 percent, which of these two projects should be accepted and rejected? (7 marks) d) Determine the net present value for each of these two projects, and advise which of them should be accepted or not. Which one is better and why? (6 marks) e) Write down the formula only to estimate the internal rate of return (IRR) for each project, without computation solve for the value of the IRR. (4 marks) f) Which evaluation methods employed above (payback period, NPV or ARR) would you recommend to give the best and most reliable result? Explain your answer with three justifications. [within 100 words] (4 marks) g) Suppose the sales volume of Avon cosmetics products have been flattened out in recent years. To maintain its future dividend growth rate and provide satisfactory return to its shareholders, Avon has decided to explore and diversify into the cloud storage business. As an analyst, you are required to evaluate a new business project. In view of this new business, would you recommend to use the same required rate of return (12 percent) used for discounting cash flows of projects A and B? Justify your recommendation with detailed explanations. [within 100 words]
