FM group assignment solution
Integrated Case
11-24
Allied Components Company
Basics of Capital Budgeting
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):
Project L
Project S
0
|
-100
-100
1
|
10
70
2
|
60
50
3
|
80
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?
Answer:
[Show S11-1 through S11-3 here.] Capital budgeting is the process of analyzing additions to fixed assets. Capital budgeting is important
because, more than anything else, fixed asset investment decisions chart a company’s course for the future. Conceptually, the capital budgeting process is identical to the decision process used by individuals making investment decisions. These steps are involved:
1.
Estimate the cash flows—interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects.
11-24
Allied Components Company
Basics of Capital Budgeting
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):
Project L
Project S
0
|
-100
-100
1
|
10
70
2
|
60
50
3
|
80
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?
Answer:
[Show S11-1 through S11-3 here.] Capital budgeting is the process of analyzing additions to fixed assets. Capital budgeting is important
because, more than anything else, fixed asset investment decisions chart a company’s course for the future. Conceptually, the capital budgeting process is identical to the decision process used by individuals making investment decisions. These steps are involved:
1.
Estimate the cash flows—interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects.