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):

Project L	-100	20	60	80
Project S	-100	70	60	20

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 15%. You must determine whether one or both of the projects should be accepted.

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

The net present value (NPV) is a method of ranking investment proposals using the NPV, which is equal to the present value of the projects free cash flows discounted at the cost of capital.

The NPV for Project L =

The NPV for Project S =

2. What is the rationale behind the NPV method?

The NPV explains how much a project contributes to shareholder wealth the larger the NPV which is equal to the present value, means a higher stock price. If the NPV is a positive value, the project is acceptable.

3. According to NPV, which project(s) should be accepted if they are independent?

If the projects were independent, both projects would be accepted because both NPVs are positive. Both projects would increase shareholder wealth, and since the cash flows of one project would not affect the other project, both would be acceptable.

4. Which project(s) should be accepted if they are mutually exclusive?

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

The NPV of a project is dependent on the WACC used. Therefore, if the WACC changed, the NPV of each project would change. The NPV declines as the WACC increases, and the NPV rises as the WACC decreases. If a firm has a low WACC, their projects have the capability to accept more projects, since their NPV is more likely to be positive.

6. Define the term internal rate of return (IRR). What is each projects IRR?

The internal rate of return (IRR) is the discount rate that forces a projects NPV to equal zero. It is used in corporate finance to measure the relative worth of projects.

The IRR for Project L =

The IRR for Project S =

7. According to IRR, which project(s) should be accepted

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

The projects IRR would not change if the WACC changed. The WACC is not included in the equation for finding IRR because it forces the NPV to equal 0. Therefore, the IRR as a number would not change. However, the decisions of whether or not projects should be changed could possibly change if the WACC changed. If the WACC increased above the IRRs, the projects would be rejected. But, if the WACC decreased and stayed below the IRRs, the projects would still be accepted.

9. What is a payback period? Find the paybacks for Projects L and S.

The payback period is the time required for the amount invested in an asset to cover its cost.

Project L Payback Period:

Project S Payback Period:

10. What is the rationale for the payback method?

The payback method is used to evaluate risk associated with a project. It gives a picture of the amount of time that the initial investment will be at risk. Analysing an investment with the payback method leads to accepting investments with shorter payback periods because they have less risk.

11. According to the payback criterion, which project(s) should be accepted if the firms maximum acceptable payback is 2 years,

12. Draw NPV profiles for Projects L and S. (This is to be done individually)

13. At what discount rate do the profiles cross?

14. Why is the NPV method preferred by academics? The NPV is preferred by academics because NPV gives an estimate of how much a potential project will contribute to shareholder wealth. Whereas executives prefer the IRR method because they believe it measures projects by the bang for your buck and it gives extra information about a projects safety margin.

15. Mini research Each member of the group is expected to find out from family, friends, work place or any other source, which methods of investment appraisal the source is using.

The response should be as follows:

Industry of Operation	Method of Investment appraisal