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 $130,000. 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 here:

	PROJECT A	PROJECT B
Initial Outlay	- $130,000	- $130,000
Inflow year 1	20,000	40,000
Inflow year 2	30,000	40,000
Inflow year 3	50,000	40,000
Inflow year 4	60,000	40,000
Inflow year 5	60,000	40,000

In evaluating these projects, please respond to the following questions:

a. The capital-budgeting process is so important because capital-budgeting decisions involve investments requiring rather _______(small, moderate, large) cash outlays at the beginning of the life of the project and commit the firm to a particular course of action over a relatively ________(short, intermediate, long) time horizon.

b. Why is it difficult to find exceptionally profitable projects?

A. There is no reliable method to accurately estimate a project's future cash flows.

B. The lack of effective investment criteria makes profitable projects hard to find.

C. The existence of competition may drive price and profit down quickly.

D. The costs of implementing capital-budgeting decisions are extremely high.

c. - What is the payback period on project A?

• If Caledonia imposes a 4-year maximum acceptable payback period, the firm should ___(accept, reject) project A because its payback period is ______(less than or equal to, greater than) the maximum acceptable payback period.

• What is the payback period on project B?

• If Caledonia imposes a 4-year maximum acceptable payback period, the firm should ______(accept, reject) project B because its payback period is ______(less than or equal to, greater than) the maximum acceptable payback period.

d. What are the criticisms of the payback period?

A. It is consistent with the firm's goal of shareholder wealth maximization.

B. The selection of the maximum acceptable payback period is arbitrary.

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?

• Caledonia should ____(accept, reject) project A because its NPV is _____(greater than or equal to, less than) zero.

• What is the NPV of project B?

• Caledonia should ____(accept, reject) project B because its NPV is ____(greater than or equal to, less than) zero.

f. Which of the following statements best describes the logic behind the NPV?

A. The net present value technique computes the number of years it takes to recapture a project's initial outlay using discounted cash flows.

B. 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.

C. The net present value technique calculates the ratio of the present value of the future free cash flows to the initial outlay.

D. The net present value technique discounts all the benefits and costs in terms of cash flows back to the present and determines the difference.

g. - What is the PI for project A?

• Caledonia should ____(accept, reject) project A because its PI is ____(greater than or equal to, less than) 1.00.

• What is the PI for project B?

• Caledonia should (accept, reject) project B because its PI is (greater than or equal to, less than) 1.00.

h. Would you expect the NPV and PI methods to give consistent accept/reject decisions?

A. The NPV and the PI always give different decisions. The project's PI is greater than 1.00 if the NPV is negative and it's less than 1.00 if the NPV is positive.

B. The NPV and the PI always give the same decision. The project's PI is greater than 1.00 if the NPV is negative and it's less than 1.00 if the NPV is positive.

C. The NPV and the PI always give the same decision. The project's PI is greater than 1.00 if the NPV is positive and it's less than 1.00 if the NPV is negative.

D. The NPV and the PI always give different decisions. The project's PI is greater than 1.00 if the NPV is positive and it's less than 1.00 if the NPV is negative.

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?

A. NPV and PI will not be affected by the change in the required rate of return.

B. NPV will be affected by the change in the required rate of return, but PI will not.

C. PI will be affected by the change in the required rate of return, but NPV will not.

D. Both NPV and PI will be affected by the change in the required rate of return.

j. - What is the IRR for project A?

• Caledonia should ____(accept, reject) project A because its IRR is _____(greater than or equal to, less than) the 12% required rate of return.

• What is the IRR for project B?

• Caledonia should ___(accept, reject) project B because its IRR is ___(greater than or equal to, less than) the 12% required rate of return.

k. How does a change in the required rate of return affect the project's internal rate of return?

A. 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.

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.

C. The required rate of return does not change the IRR for a project, neither does it affect whether a project is accepted or rejected.

D. The required rate of return does not change the IRR for a project, but it does affect whether a project is accepted or rejected.

l. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?

A. 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.

B. 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.

C. 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.

D. 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.