Capital Budgeting
The Basics of Capital Budgeting
Integrated Case Study
Allied Components Company
You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, 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 firm’s 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’ net cash flows (in thousands of dollars):
0 1 2 3 | | | | Project L -100 10 60 80 Project S -100 70 50 20
Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted.
A. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions?
B. What is the difference between independent and mutually exclusive projects? Between projects with normal and nonnormal cash flows?
C. (1) Define the term net present value (NPV). What is each project’s NPV?
C. (2) What is the rationale behind the NPV method? According to NPV, which project(s) should be accepted if they are independent? Mutually exclusive?
C. (3) Would the NPVs change if the WACC changed? Explain.
D. (1) Define the term internal rate of return
Integrated Case Study
Allied Components Company
You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, 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 firm’s 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’ net cash flows (in thousands of dollars):
0 1 2 3 | | | | Project L -100 10 60 80 Project S -100 70 50 20
Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted.
A. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions?
B. What is the difference between independent and mutually exclusive projects? Between projects with normal and nonnormal cash flows?
C. (1) Define the term net present value (NPV). What is each project’s NPV?
C. (2) What is the rationale behind the NPV method? According to NPV, which project(s) should be accepted if they are independent? Mutually exclusive?
C. (3) Would the NPVs change if the WACC changed? Explain.
D. (1) Define the term internal rate of return