Aluminum Building Products Company (ABPC) is considering investing in either of the two mutually exclusive projects described as follows:
Project 1. Buying a new set of roll-forming tools for its existing roll forming line to introduce a new cladding product. After its introduction, the product will need to be promoted. This means that cash inflows from additional production will start sometime after and will gradually pick up in subsequent periods.
Project 2. Modifying its existing roll-forming line to increase productivity of its available range of cladding products. Cash inflows from additional production will start immediately and will reduce over time as the products move through their life cycle. Sarah Brown, project manager of ABPC, has requested that you do the necessary financial analysis and give your opinion about which project ABPC should select.
The projects have the following net cash flow estimates:
Year project 1 project 2
0 (200,000) (200,000)
1 0 90,000
2 0 70,000
3 20,000 50,000
4 30,000 30,000
5 40,000 10,000
6 60,000 10,000
7 90,000 10,000
8 100,000 10,000
Both these projects have the same economic life of eight years and average risk characteristics. ABPCâs weighted average cost of capital, or hurdle rate, is 7.2 percent.
a ) Which project would you recommend Ms. Brown accept to maximize value of the firm? (Hint: Calculate and compare NPVs of both projects.)
b) What are the IRRs of each project? Which project should be chosen using IRR as the selection criterion?
c) Draw the NPV profiles of both projects. What is the approximate discount rate at which both projects would have the same NPC? what is that NPV?
d) Does the selection remain unaffected for i) WACC> 5.4 percent; ii) WACC > 8.81 percent; and iii) WACC > 14.39 percent?
e) Further market survey research indicates that both projects have lower- than- average risk and, hence, the risk- adjusted discount rate should be 5 percent. What happens to the ranking of the projects using NPV and IRR as the selection criteria? Explain the conflict in ranking, if any.
f) Answer questions a, d, e, assuming the projects are independent of each other.
