Case 1 Caledonia Products Integrative Problem Fin 370

Caladonia Products Integrative Problem

FIN 370

As a newly assigned assistant financial analyst at Caledonia Products, Team D has been charged with

calculating the cost of two projects, projected returns, cost of equipment, and finally a recommendation

as to which project to pursue and why. In order to make a recommendation we need all potential cost

incurred, unit price, projected sales, and market information.

The cash flows associated with these projects are as follows:

|YEAR |PROJECT A |PROJECT B |
|0 |–$100,000 |–$100,000 |
|1 |32,000 |0 |
|2 |32,000 |0 |
|3
|32,000 |0 |
|4 |32,000 |0 |
|5 |32,000 |$200,000 |

The required rate of return on these projects is 11%.

1. What is each project’s payback period?

Project A’s payback period is 3.125 years... $100,000 / $32,000 = 3.125 Meaning that in 3.125 years, there will be an influx of $100,000.

Project B’s payback period is 4.5 years... Meaning that in 4.5 years, there will be an influx of $200,000.

2. What is each project’s net present value?

Project A’s net present value would be $18,269 and Project B’s net present value would be $18,690.

3. What is each project’s internal rate of return?

While Project A’s IRR is 18.03%, Project B’s IRR is 14.87%.

d. What has caused the ranking conflict?

The conflict in the rankings is caused by the different assumptions made by the NPV and IRR decision criteria for reinvestment. The Internal Rate of Return way assumes the cash flows can only be reinvested over the life of the project at the internal rate of return. The Net Present Value way assumes that the cash flows can use the rate of return or the cost of capital as a basis for the reinvestment.

e. Which project should be accepted? Why?

Project B should be taken because it has the larger Net Present Value.
The Net Present Value application is the preferred route to take because it is most used assumption when trying to maximize wealth.

Lease vs. Buy

Factors that affect Caldonia’s decision to buy or lease the equipment are as follows;

Benefits of purchasing the equipment for the projects are that it may be difficult to find a company that

would lease the equipment because of the exclusivity of the task the equipment performs. Although the

equipment is expensive it could perform the task needed for either project that Caldonia decides on.

Additionally, the Equipment for project A has a short life cycle of three years and would be difficult to

find a company willing to lease it.

Benefits to leasing the equipment needed for the project is the depreciation, the equipment if purchased

would be sold at a loss because it would be difficult to resale the equipment once the project is

terminated because the equipment provides an exclusive task and may be obsolete in five years. In

Addition, the life cycle of the equipment for B is nine years which would still have use the five years

needed for the project. So, it may be feasible for a company to lease this
equipment.

Recommendation

It is our recommendation to the CEO of Caledonia that we pursue Project B. This recommendation is

on the basis that Project B meets the benchmark of 11% and although shows a 3.16% less IRR than

project A, Project B has A larger present value. Project B equipment would also be a more flexible

option, in that it may be leased because of its nine year life cycle, require less maintenance, and not

hinder production to replace worn machinery past its life cycle.

REFRENCES:

Keown A. J., Martin, J. D., Petty, J. W., & Scott, D. F. (2005). Financial management: Principles and applications (10th ed.). Upper Saddle River, NJ: Pearson/Prentice Hall. Ch.10