Question

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 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 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’ after-tax cash flows (in thousands of dollars): A timeline shows values for Projects L and S over 3 years. The data from the timeline, presented in the format, project, 0, 1, 2, 3, are as follows. L, negative $100, $10, $60, $80. S, negative $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 projects should be accepted.

Answer 1

Answer:

Both projects should be accepted as their cash-flow 's present values are all positive once they are discounted at WACC rate.

Explanation:

To find whether one or both projects should be accepted, we have to calculate the present value of the two cash-flows each project generates. Besides, both projects have the same risk characteristics as the firm's average project, WACC should be used as a discount rate.

- Project L present value (in thousands of dollars) = -100 + 10/1.1^1 + 60/1.1^2 + 80/1.1^3 = $18.783

- Project S present value (in thousands of dollars) = -100 +70/1.1 + 50/1.1^2 + 20/1.1^3 = $19.985

As both projects generate positive discounted cash-flow, both of them should be accepted.