You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler AG, Ford, Toyota, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project 1, 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 5 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’ after-tax cash flows (in thousands of dollars);
0 1 2 3
Project 1 -100 $10 $60 $80
Project 5 -100 $70 $50 $20
Depreciation, salvage values, net operating 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 project should be accepted
a. Find the MIRRs for Projects L and S.
b. find the paybacks for project L and S
c. What is the rationale for the payback method? According to the payback criterion, which project(s) should be accepted if te firm’s maximum acceptable payback is 2 years, if Project L and S are independent? If Project L and S are mutually exclusive?
d. What is the difference between the regular and discounted payback method?
e. What are the two main disadvantages of discounted payback? Is the payback method useful in capital budgeting decisions? Explain.
f . As a separate project (Project P), the firm is considering sponsoring a pavilion at the upcoming World’s Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project P’s expected cash flows (in millions of dollars) look like this:
0 1 2
-$0.8 $5.0 -$5.0
The project is estimated to be of average risk, so its WACC is 10%.
1. What is Project P’s NPV? What is its IRR? Its MIRR?
2. Draw Project P’s NPV profile. Does Project P have normal or non-normal cash flows? Should this project be accepted? Explain.