Caledonia Project

FIN/370

Julie Vogt

January 9, 2012

Week 4 Team project was to answer question 12 a-e on page 363, Chapter 10 of Financial Management: Principles and Applications. 12. Caledonia is considering two additional mutually exclusive projects. 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 percent. a. What is each project’s payback period? According to Financial Management: Principles and Applications Payback period is defined as “A capital-budgeting criterion defined as the number of years required to recover the initial cash investment” (Keown, Martin, Petty, & Scott, 2005, p. 292).

The equation for payback period is:

Payback period = Investment required / Net Annual Cash or Payback period = Y + (A / B) Y = the number of years before final payback year

A = Total remaining to be paid back

B = Total (net) paid back in the entire payback of the year

(Keown, Martin, Petty, & Scott, 2005, p. 292).

Project A - payback period is 3.125 years.

The initial investment is $100,000. Each year Caledonia accumulates $32,000. Within a three-year period, $96,000 will be recovered ($32,000 x 3 = $96,000). The amount left from the initial investment is $4,000 ($100,000 - $96,000 = $4,000). This amount will be recovered in the fourth year. To recover the remaining $4,000, it will take an additional .125 years ($4,000/$32,000 = .125).

The formula used to come up with this was Payback period =

3 + ($4,000/$32,000) = 3 + .125 = 3.125 years

Project B - payback period is 4.5 years.

The initial investment is $100,000. It is assumed that Caledonia has no recovery until the fourth year. In the fifth year $200,000 is received. To determine how much into the 5th year it took Caledonia to recover the initial $100,000 investment, the payback period formula is used ($100,000/$200,000 = .5)

The formula used to come up with this was Payback period =

4 + ($100,000/$200,000) = 4 + .5 = 4.5 years

b. What is each project’s net present value? According to Financial Management: Principles and Applications Net present value is defined as “A capital-budgeting decision criterion defined as the present value of the free cash flows after tax less the project’s initial outlay” (Keown, Martin, Petty, & Scott, 2005, p. 295).

The formula for Net Present Value (NPV) is: This is equation 9-1, page 295.

NPV = or

NPV = Cash Flow * PVIFA – Initial outlay This is on page 296, Table 9-5. Appendix E is used to find the PVIFA for this problem.

Per Financial Management: Principles and Applications, the variables are defined as: FCFt = the annual free cash flow in time period t (can be either positive or negative). K = the appropriate discount rate: that is, the required rate of return or cost of capital IO = the initial cash outlay

N = the project’s expected life

(Keown, Martin, Petty, & Scott, 2005, p. 295).

PVIFA = Present-value interest for an annuity (Keown, Martin, Petty, & Scott, 2005, p. 155).

Project A = Even cash flow each year.

NPVa = FCF (PVIFA 11%, 5yrs) – IO

NPVa = $15,000 (3.696) - $100,000

NPVa = $118,272 - $100,000

NPVa = $18,272

Project B = Uneven cash flow each year.

Formula used in NPVb = Free cash flow / (1 + discount rate) – Initial Cash Outlay Equation (9-1) on page 295. NPVb $200,000 / (1 + .11) - $100,000

NPVb = $180,180.18 - $100,000

NPVb = $80,180.18

c. What is each project’s internal rate of return? According to Financial Management: Principles and Applications Internal rate of return is defined as “A capital-budgeting decision criterion that reflects the rate of...

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