FNCE20005 Lecture Notes - Lecture 4: Net Present Value

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pinkporcupine846

7 Sep 2018

School

University of Melbourne

Department

Finance

Course

FNCE20005

Professor

ALL

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Document Summary

Mutually exclusive projects with di erent lives: assessing mutually exclusive projects. Example: the student union is considering investing in either a beverage automatic distributor (bad) or a sweet-and-direct (sad) machine. Equivalent annual value (eav) method: constant chain of replacement (ccr) method. Therefore, recommend project sad over project bad: what if we have two projects with 21 and 23 years, i. e. lcm=483. Lcm method can be very cumbersome: instead of nding lcm, assume project exists forever. Perpetuity method: make lengths of the chains equal by making them in nite. In other words, both projects are replicated forever. Eav method: consider an annuity over n years, eav = annual cash ow from an annuity that has the same life as the project and whose present value is equal to standard npv of the project. Converting the npv value into an annuity - same cash ow every year over the life of the project.

Related Questions

Your first assignment in your new position as assistant financial analyst at Caledonia Products is to evaluate two new capital-budgeting proposals. Because this is your first assignment, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at assessing your understanding of the capital-budgeting process. This is a standard procedure for all new financial analysts at Caledonia, and it will serve to determine whether you are moved directly into the capital-budgeting analysis department or are provided with remedial training. The memorandum you received outlining your assignment follows:

To: The New Financial Analysts
From: Mr. V. Morrison, CEO, Caledonia Products
Re: Capital-Budgeting Analysis

Provide an evaluation of two proposed projects, both with 5-year expected lives and identical initial outlays of
$110,000. Both of these projects involve additions to Caledoniaâs highly successful Avalon product line, and as
a result, the required rate of return on both projects has been established at 12 percent. The expected free cash
flows from each project are as follows:

	Project A	Project B
Initial outlay	-$110,000	-$110,000
Inflow year 1	20,000	40,000
Inflow year 2	30,000	40,000
Inflow year 3	40,000	40,000
Inflow year 4	50,000	40,000
Inflow year 5	70,000	40,000

In evaluating these projects, please respond to the following questions. For questions from (a) to (j) assume that the projects are independent. That is both could be accepted if both are acceptable.
a. What is the payback period on each project? If Caledonia imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?
b. What are the criticisms of the payback period?
c. Determine the NPV for each of these projects. Should they be accepted?
d. Describe the logic behind the NPV.
e. Determine the PI for each of these projects. Should they be accepted?
f. Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
g. Determine the IRR for each project. Should they be accepted?
h. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?
i. Determine the MIRR for each project. Should they be accepted?
j. Describe the logic behind the MIRR.
k. Rank the two project based on all above criteria and make a recommendation as to which (if either) should be
accepted under the assumption that the projects are mutually exclusive.

l. Caledonia is considering two additional mutually exclusive projects. The free cash flows associated with these projects are as follows:

	Project A	Project B
Initial outlay	-$100,000	-$100,000
Inflow year 1	32,000	0
Inflow year 2	32,000	0
Inflow year 3	32,000	0
Inflow year 4	32,000	0
Inflow year 5	32,000	200,000

The required rate of return on these projects is 11 percent.
1. What is each projectâs payback period?
2. What is each projectâs NPV?
3. What is each projectâs IRR?
4. What has caused the ranking conflict?
5. Which project should be accepted? Why?

I ONLY NEED TO DO PART l. (the last question) I need to answer questions 1-5

ochreworm751

FNCE20005 Lecture Notes - Lecture 4: Net Present Value

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