Assume that you recently went to work for Axis Components Company, a supplier of

Question

Assume that you recently went to work for Axis Components Company, a supplier of auto repair

parts used in the after-market with products from GM, Ford, and other auto makers. 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 Axis is planning to introduce entirely new models

after 3 years.

Here are the projects’ net cash flows (in thousands of dollars):

Expected Net Cash Flow

0                     ($100)                       ($100)

1                    10                                70

2                      60                               50

3                     80                                  20

in these cash flows.

The CFO also made subjective risk assessments of each project, and he concluded that both

projects have risk characteristics which are similar to the firm’s average project. Axis’s weighted

average cost of capital is 10 percent. You must now determine whether one or both of the projects

should be accepted.

a. What is capital budgeting?

b. What is the difference between independent and mutually exclusive projects?

c. (1) What is the payback period? Find the paybacks for Projects L and S.

(2) What is the rationale for the payback method? According to the payback criterion,

which project or projects should be accepted if the firm’s maximum acceptable payback

is 2 years, and if Projects L and S are independent? If they are mutually exclusive?

(3) What is the difference between the regular and discounted payback periods?

(4) What is the main disadvantage of discounted payback? Is the payback method of any real

usefulness in capital budgeting decisions?

d. (1) Define the term

(2) What is the rationale behind the NPV method? According to NPV, which project or

projects should be accepted if they are independent? Mutually exclusive?

Explanation / Answer

Capital budgeting is the process of allocating funds to variousprojects. In this case, we are trying to decide whether toinvest in neither, one, or both projects. Independent projects can be completed with or without completion ofother projects. Mutually exclusive projects can only becompleted if the others are not completed. -100 + 10 + 60 < 0 -100 + 10 + 60 + 80 > 0 --> payback period is between 2 and 3years 80 * x = 100 - 10 - 60 = 30 x = 3/8 = .375 Payback period is 2.375 years (3 years if we want an integernumber) -100 + 70 < 0 -100 + 70 + 50 > 0 --> payback period is between 1 and 2years 50 * x = 100 - 70 = 30 x = 3/5 = .6 Payback period is 1.6 years (2 years if we want an integernumber) The payback period is the time to payback the initial expenditureon the investment. Since you want your investment paid backsooner rather than later, a shorter payback time is better. Since the require payback time is 2 years, we would only accept the2nd project which has a payback period of 1.6 (2) years. Wewould make this decision if the events were independent or mutuallyexclusive. In the discounted payback period method, we take into account thetime value of money and discount any cash flow by the interestrate. Therefore, 10 dollars in year two is worth less than 10dollars in year 1. The advantage is that it more accuratelyrepresents the value of the future cash flows. However, onthe other hand, it is more difficult to compute making it lesspopular. Regardless though, the payback period is not a goodbasis for making investment decisions as we are interested inprofit, not the time to pay back. The net present value is the current value of future cashflows. The PV of a cash flow of C in year n and rate r is C /(1+r)^n. NPV = -100 + 10/1.1 + 60/1.1^2 + 80/1.1^3 = 18.78 NPV = -100 + 70/1.1 + 50/1.1^2 + 20/1.1^3 = 19.98 Since both have NPV > 0, both should be accepted if possible(independent). However, if they are mutually exclusive, wechoose the one with the greater NPV and therefore choose the 2ndproject.

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