What is capital budgeting

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Reference no: EM132210535

Problem - Your boss, the chief financial officer (CFO) for Southern Textiles, has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm's fabric 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 three-year lives because Southern is planning to introduce an entirely new fabric at that time.

Here are the net cash flow estimates (in thousands of dollars):

Year	Expected Net Cash Flows
Year	Project L	Project S
0	$(100)	$(100)
1	10	70
2	60	50
3	80	20

The CFO also made subjective risk assessments of each project, and he concluded that the projects both have risk characteristics that are similar to the firm's average project. Southern's required rate of return is 10 percent. You must now determine whether one or both of the projects should be accepted. Start by answering the following questions:

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 conventional cash flows and projects with unconventional cash flows?

c. (1) What is the payback period? Find the traditional payback periods for Project L and Project S.

(2) What is the rationale for the payback measure? According to the payback criterion, which project or projects should be accepted if the firm's maximum acceptable payback is two years and Project L and Project S are independent? Mutually exclusive?

(3) What is the difference between the traditional payback and the discounted payback? What is each project's discounted payback?

(4) What are the main disadvantages of the traditional payback? Is the payback method of any real usefulness in capital budgeting decisions?

(5) Define the term net present value (NPV). What is each project's NPV?

(6) What is the rationale behind the NPV method? According to NW, which project or projects should be accepted if they are independent? Mutually exclusive?

(7) Would the NPVs change if the required rate of return changed?

(8) Define the term internal rate of return (IRR). What is each project's IRR?

(9) How is the IRR on a project related to the YTM on a bond?

(10) What is the logic behind the IRR method? According to IRR, which projects should be accepted if they are independent? Mutually exclusive?

(11) Would the projects' 111Rs change if the required rate of return changed? Explain.

(12) Construct the NPV profiles for Project L and Project S. At what discount rate do the profiles cross?

(13) Look at the NPV profile graph without referring to the actual NPVs and IRRs. Which project or projects should be accepted if they are independent? Mutually exclusive? Explain. Do your answers differ depending on the discount rate used? Explain.

(14) What is the underlying cause of ranking conflicts between NPV and IRR?

(15) What is the reinvestment rate assumption, and how does it affect the NPV versus IRR conflict?

(16) Which capital budgeting method should be used when NPV and IRR give conflicting rankings? Why?

(17) Define the term modified internal rate of return (MIRK What is each project's MIRR?

(18) What is the rationale behind the MIRR method? According to MIRR, which project or projects should be accepted if they are independent? Mutually exclusive?

(19) Would the MIRRs change if the required rate of return changed?

Reference no: EM132210535

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