Your first assignment in your new position as assistant financial analyst at Caledonia Products is to evaluate two new capital-budgeting proposals. Because this is your first assignment, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at assessing your understanding of the capital-budgeting process. This is a standard procedure for all new financial analysts at Caledonia, and it will serve to determine whether you are moved directly into the capital-budgeting analysis department or are provided with remedial training. The memorandum you received outlining your assignment follows: To: New Financial Analysts From: Mr. V. Morrison, CEO, Caledonia Products Re: Capital-Budgeting Analysis Provide an evaluation of two proposed projects, both with 5-year expected lives and identical initial outlays of $150,000. Both of these projects involve additions to Caledonia's highly successful Avalon product line, and as a result, the required rate of return on both projects has been established at 12 percent. The expected free cash flows from each project are shown in the popup window: In evaluating these projects, please respond to the following questions: a. Why is the capital-budgeting process so important? b. Why is it difficult to find exceptionally profitable projects? c. What is the payback period on each project? If Caledonia imposes a 4-year maximum acceptable payback period, which of these projects should be accepted? d. What are the criticisms of the payback period? e. Determine the NPVE V for each of these projects. Should either project be accepted? f. Describe the logic behind the NPV. 9. Determine the Pl for each of these projects. Should either project be accepted? h h. Would you expect the NPV and Pl methods to give consistent accept/reject decisions? Why or why not? PI i. What would happen to the NPV and PI for each project if the required rate of return increased? If the required rate of return decreased? j. Determine the IRR for each project. Should either project be accepted? k. How does a change in the required rate of return affect the project's internal rate of return? 1. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better? 1 Data table (Click on the following icon in order to copy its contents into a spreadsheet.) PROJECT A PROJECT B Initial outlay - $150,000 - $150,000 Inflow year 1 10,000 40,000 Inflow year 2 30,000 40,000 Inflow year 3 50,000 40,000 Inflow year 4 40,000 40,000 Inflow year 5 60,000 40,000 Print Done cash outlays at the beginning of the life of the project and commit the firm to a particular course of action over a. The capital-budgeting process is so important because capital-budgeting decisions involve investments requiring rather a relatively time horizon. (Select from the drop-down menus.) b. Why is it difficult to find exceptionally profitable projects? (Select the best choice below.) O A. The existence of competition may drive price and profit down quickly. O B. There is no reliable method to accurately estimate a project's future cash flows. OC. The costs of implementing capital-budgeting decisions are extremely high. OD. The lack of effective investment criteria makes profitable projects hard to find. c. What is the payback period on project A? years (Round to two decimal places.) If Caledonia imposes a 4-year maximum acceptable payback period, the firm should project A because its payback period is the maximum acceptable payback period. (Select from the drop-down menus.) What is the payback period on project B? years (Round to two decimal places.) If Caledonia imposes a 4-year maximum acceptable payback period, the firm should project because its payback period is the maximum acceptable payback period. (Select from the drop-down menus.) d. What are the criticisms of the payback period? (Select all that apply.) A. The selection of the maximum acceptable payback period is arbitrary. B It is consistent with the firm's goal of shareholder wealth maximization. C. The method does not take into account the time value of money. D. The method ignores cash flows occurring after the payback period. e. What is the NPV of project A? $ (Round to the nearest cent.) Caledonia should project A because its NPV is zero. (Select from the drop-down menus.) What is the NPV of project B? $(Round to the nearest cent.) Caledonia should V project B because its NPV is zero. (Select from the drop-down menus.) f. Which of the following statements best describes the logic behind the NPV? (Select the best choice below.) O A. The net present value technique discounts all the benefits and costs in terms of cash flows back to the present and determines the difference. OB. The net present value technique computes the number of years it takes to recapture a project's initial outlay using discounted cash flows. O C. The net present value technique finds the discount rate that equates the present value of the project's free cash flows with the project's initial cash outlay. OD. The net present value technique calculates the ratio of the present value of the future free cash flows to the initial outlay. g. What is the pl for project A? (Round to three decimal places.) Caledonia should V project A because its Plis 1.00. (Select from the drop-down menus.) What is the Pl for project B? (Round to three decimal places.) Caledonia should project B because its Plis V 1.00. (Select from the drop-down menus.) h. Would you expect the NPV and Pl methods to give consistent accept/reject decisions? (Select the best choice below.) O A. The NPV and the Pl always give different decisions. The project's Pl is greater than 1.00 if the NPV is positive and it's less than 1.00 if the NPV is negative. OB. The NPV and the Pl always give the same decision. The project's Pl is greater than 1.00 if the NPV is positive and it's less than 1.00 if the NPV is negative. O C. The NPV and the Pl always give the same decision. The project's Pl is greater than 1.00 if the NPV is negative and it's less than 1.00 if the NPV is positive. OD. The NPV and the Pl always give different decisions. The project's Pl is greater than 1.00 if the NPV is negative and it's less than 1.00 if the NPV is positive. i. What would happen to the NPV and PI for each project if the required rate of return increased? If the required rate of return decreased? (Select the best choice below.) O A. Both NPV and P/ will be affected by the change in the required rate of return. O B. NPV will be affected by the change in the required rate of return, but P/ will not. OC. NPV and P/ will not be affected by the change in the required rate of return. OD. Pl will be affected by the change in the required rate of return, but NPV will not. j. What is the IRR for project A? % (Round to two decimal places.) Caledonia should project A because its IRR is the 12% required rate of return. (Select from the drop-down menus.) What is the IRR for project B? % (Round to two decimal places.) Caledonia should project B because its IRR is the 12% required rate of return. (Select from the drop-down menus.) k. How does a change in the required rate of return affect the project's internal rate of return? (Select the best choice below.) O A. The required rate of return does not change the IRR for a project, but it does affect whether a project is accepted or rejected. B. The required rate of return does change the IRR for a project, but it does not affect whether a project is accepted or rejected. O C. The required rate of return does not change the IRR for a project, neither does affect whether project is accepted or rejected. OD. The required rate of return does not only change the IRR for a project, but it also affects whether a project is accepted or rejected. 1. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better? (Select the best choice below.) O A. The IRR assumes that all cash flows over the life of the project are reinvested over the remainder of the project's life at the internal rate of return and, thus, is preferred. OB. The NPV assumes that all cash flows over the life of the project are reinvested at the required rate of return and, thus, is preferred. O C. The IRR assumes that all cash flows over the life of the project are reinvested at the required rate of return and, thus, is preferred. OD. The NPV assumes that all cash flows over the life of the project are reinvested over the remainder of the project's life at the internal rate of return and, thus, is preferred. Your first assignment in your new position as assistant financial analyst at Caledonia Products is to evaluate two new capital-budgeting proposals. Because this is your first assignment, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at assessing your understanding of the capital-budgeting process. This is a standard procedure for all new financial analysts at Caledonia, and it will serve to determine whether you are moved directly into the capital-budgeting analysis department or are provided with remedial training. The memorandum you received outlining your assignment follows: To: New Financial Analysts From: Mr. V. Morrison, CEO, Caledonia Products Re: Capital-Budgeting Analysis Provide an evaluation of two proposed projects, both with 5-year expected lives and identical initial outlays of $150,000. Both of these projects involve additions to Caledonia's highly successful Avalon product line, and as a result, the required rate of return on both projects has been established at 12 percent. The expected free cash flows from each project are shown in the popup window: In evaluating these projects, please respond to the following questions: a. Why is the capital-budgeting process so important? b. Why is it difficult to find exceptionally profitable projects? c. What is the payback period on each project? If Caledonia imposes a 4-year maximum acceptable payback period, which of these projects should be accepted? d. What are the criticisms of the payback period? e. Determine the NPVE V for each of these projects. Should either project be accepted? f. Describe the logic behind the NPV. 9. Determine the Pl for each of these projects. Should either project be accepted? h h. Would you expect the NPV and Pl methods to give consistent accept/reject decisions? Why or why not? PI i. What would happen to the NPV and PI for each project if the required rate of return increased? If the required rate of return decreased? j. Determine the IRR for each project. Should either project be accepted? k. How does a change in the required rate of return affect the project's internal rate of return? 1. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better? 1 Data table (Click on the following icon in order to copy its contents into a spreadsheet.) PROJECT A PROJECT B Initial outlay - $150,000 - $150,000 Inflow year 1 10,000 40,000 Inflow year 2 30,000 40,000 Inflow year 3 50,000 40,000 Inflow year 4 40,000 40,000 Inflow year 5 60,000 40,000 Print Done cash outlays at the beginning of the life of the project and commit the firm to a particular course of action over a. The capital-budgeting process is so important because capital-budgeting decisions involve investments requiring rather a relatively time horizon. (Select from the drop-down menus.) b. Why is it difficult to find exceptionally profitable projects? (Select the best choice below.) O A. The existence of competition may drive price and profit down quickly. O B. There is no reliable method to accurately estimate a project's future cash flows. OC. The costs of implementing capital-budgeting decisions are extremely high. OD. The lack of effective investment criteria makes profitable projects hard to find. c. What is the payback period on project A? years (Round to two decimal places.) If Caledonia imposes a 4-year maximum acceptable payback period, the firm should project A because its payback period is the maximum acceptable payback period. (Select from the drop-down menus.) What is the payback period on project B? years (Round to two decimal places.) If Caledonia imposes a 4-year maximum acceptable payback period, the firm should project because its payback period is the maximum acceptable payback period. (Select from the drop-down menus.) d. What are the criticisms of the payback period? (Select all that apply.) A. The selection of the maximum acceptable payback period is arbitrary. B It is consistent with the firm's goal of shareholder wealth maximization. C. The method does not take into account the time value of money. D. The method ignores cash flows occurring after the payback period. e. What is the NPV of project A? $ (Round to the nearest cent.) Caledonia should project A because its NPV is zero. (Select from the drop-down menus.) What is the NPV of project B? $(Round to the nearest cent.) Caledonia should V project B because its NPV is zero. (Select from the drop-down menus.) f. Which of the following statements best describes the logic behind the NPV? (Select the best choice below.) O A. The net present value technique discounts all the benefits and costs in terms of cash flows back to the present and determines the difference. OB. The net present value technique computes the number of years it takes to recapture a project's initial outlay using discounted cash flows. O C. The net present value technique finds the discount rate that equates the present value of the project's free cash flows with the project's initial cash outlay. OD. The net present value technique calculates the ratio of the present value of the future free cash flows to the initial outlay. g. What is the pl for project A? (Round to three decimal places.) Caledonia should V project A because its Plis 1.00. (Select from the drop-down menus.) What is the Pl for project B? (Round to three decimal places.) Caledonia should project B because its Plis V 1.00. (Select from the drop-down menus.) h. Would you expect the NPV and Pl methods to give consistent accept/reject decisions? (Select the best choice below.) O A. The NPV and the Pl always give different decisions. The project's Pl is greater than 1.00 if the NPV is positive and it's less than 1.00 if the NPV is negative. OB. The NPV and the Pl always give the same decision. The project's Pl is greater than 1.00 if the NPV is positive and it's less than 1.00 if the NPV is negative. O C. The NPV and the Pl always give the same decision. The project's Pl is greater than 1.00 if the NPV is negative and it's less than 1.00 if the NPV is positive. OD. The NPV and the Pl always give different decisions. The project's Pl is greater than 1.00 if the NPV is negative and it's less than 1.00 if the NPV is positive. i. What would happen to the NPV and PI for each project if the required rate of return increased? If the required rate of return decreased? (Select the best choice below.) O A. Both NPV and P/ will be affected by the change in the required rate of return. O B. NPV will be affected by the change in the required rate of return, but P/ will not. OC. NPV and P/ will not be affected by the change in the required rate of return. OD. Pl will be affected by the change in the required rate of return, but NPV will not. j. What is the IRR for project A? % (Round to two decimal places.) Caledonia should project A because its IRR is the 12% required rate of return. (Select from the drop-down menus.) What is the IRR for project B? % (Round to two decimal places.) Caledonia should project B because its IRR is the 12% required rate of return. (Select from the drop-down menus.) k. How does a change in the required rate of return affect the project's internal rate of return? (Select the best choice below.) O A. The required rate of return does not change the IRR for a project, but it does affect whether a project is accepted or rejected. B. The required rate of return does change the IRR for a project, but it does not affect whether a project is accepted or rejected. O C. The required rate of return does not change the IRR for a project, neither does affect whether project is accepted or rejected. OD. The required rate of return does not only change the IRR for a project, but it also affects whether a project is accepted or rejected. 1. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better? (Select the best choice below.) O A. The IRR assumes that all cash flows over the life of the project are reinvested over the remainder of the project's life at the internal rate of return and, thus, is preferred. OB. The NPV assumes that all cash flows over the life of the project are reinvested at the required rate of return and, thus, is preferred. O C. The IRR assumes that all cash flows over the life of the project are reinvested at the required rate of return and, thus, is preferred. OD. The NPV assumes that all cash flows over the life of the project are reinvested over the remainder of the project's life at the internal rate of return and, thus, is preferred