Caladonia Products Integrative Problem Essays

Caladonia Products Integrative Problem Essays Caladonia Products Integrative Problem Essay Caladonia Products Integrative Problem Essay Caladonia Products Integrative Problem Tonia Tolliver, Suany Gonzalez, Teresa Powell, Victor Estrada, and Tracy Harriss FIN/370 November 8th, 2010 Joe Brennan Caladonia Products Integrative Problem Every new employee is faced with the challenge of proving him or herself before being trusted to complete a task on his or her own without supervision. The new financial analyst at Caladonia has been employed for two months and has proven to be a wise hiring decision based on the Chief Executive Officer (CEO) view however he is still hesitant to give the assistant any large responsibilities without supervision. The CEO has tasked the assistant with both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects (Keown, Martin, Perry, Scott, 2005). The lack of experience on the assistants part has also lead to the CEO requesting not only that the assistant provide a recommendation but also to respond to a number of questions aimed at judging the assistants understanding of the capital budgeting process (Keown, Martin, Perry, Scott, 2005). Financial Assistants Assignment The financial assistant received the important assignment by memorandum from the CEO. The memorandum stated that the company is considering the introduction of a new product (Keown, Martin, Perry, Scott, 2005). Caradonia is currently at a 34% marginal tax bracket with a 15% required rate of return or cost of capital (Keown, Martin, Perry, Scott, 2005). The new project is estimated to last five years and then be terminated because of being a fad project (Keown, Martin, Perry, Scott, 2005). The financial assistant must analyze two mutually exclusive projects. Each project has an 11% rate of return and a life span of five years (Keown, Martin, Perry, Scott, 2005). The following table (table one) shows the expected cash flows for each project. Table One Estimated Cash Flows of Caldonia Products Project A and Project B 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 | Questions to Answer The financial analyst has been tasked with answering five questions. 1. What is each projects payback period? 2. What is each projects net present value? 3. What is each projects internal rate of return? 4. What has caused the ranking conflict? 5. Which project should be accepted? Why? Answers to Questions Question One – Payback Period Project A. T he payback period for Project A is 3. 125 years. To calculate the payback period for project A, the analyst used the following formula: 3+ (100,000/32,000) = 3. 125 Project B. The payback period for Project B is 4. 5 years. To calculate the payback period for project B, the analyst used the following formula: 4+ (100,000/200,000) = 4. 500 Based on the payback periods, the assistant determined that Project B assumes even cash flow throughout year 5. Question Two – Net Present Value Project A. Each of the cash inflows are discounted back to the present value. The Net Present Value is the sum of the present values. [pic] t The time of the cash flow (5 years) i The discount rate (11%) Rt The net cash flow (-$100,000, $32,000, $32,000, $32,000, $32,000, $32,000) amount of cash, inflow minus outflow) at time t. NPV- Project A | | | | |Year |Cash Flow |PV Factor @ 11% |PV | |0 |($100,000) |1 |($100,000) | |1 |$32,000 |0. 9009 |$28,829 | |2 |$32,000 |0. 8116 |$25,972 | |3 |$32,000 |0. 7312 |$23,398 | |4 |$32,000 |0. 587 |$21,079 | |5 |$32,000 |0. 5935 |$18,990 | |NPV- Project A |$18,268. 70 | | | Project B. Each of the cash inflows are discoun ted back to the present value. The Net Present Value is the sum of the present values. [pic] t The time of the cash flow (5 years) i The discount rate (11%) Rt The net cash flow (-$100,000, $0, $0, $0, $0, $200,000) amount of cash, inflow minus outflow) at time t. NPV- Project B | | | | |Year |Cash Flow |PV Factor @ 11% |PV | |0 |($100,000) |1 |($100,000) | |1 |$0 |0. 9009 |$0 | |2 |$0 |0. 8116 |$0 | |3 |$0 |0. 312 |$0 | |4 |$0 |0. 6587 |$0 | |5 |$200,000 |0. 5935 |$118,690 | |NPV- Project B |$18,690. 27 | | | Question Three – Internal Rate of Return The internal rate of return measures and compares the profitability of investments. The formula for IRR is IRR = n ? FCFt = 10 t=1 (1+IRR)^t |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 | | | | | |IRR |18. 03% |14. 7% | Question Four – Cause of the Ranking Conflict The causes of the ranking conflict are the differi ng reinvestment assumptions made by Net Present Value and the Internal Rate of return. Net Present Value criteria assumes that cash flows over the life of the project can be reinvested at the required rate of return or cost of capital, whereas the Internal Rate of Return criterion implicitly assumes that the cash flows over the life of the project can be reinvested at the internal rate of return. Question Five – Which project should be accepted and why? Multiple factors should be considered before choosing which product that should be accepted. Those factors are the internal rate of return (IRR) and the net present value (NPV). Looking at Project B, it is possible to conclude that it is the more viable project because the internal rate of return is shorter. Though the net values shown between the two are very close monetarily, Project B can produce its value at a much shorter time span, meaning a business would be able to reap the benefits from Project B faster than if they went with Project A. The time difference is about a year and a half with a return rate of about three percent difference in the two projects. If Project A was chosen, it would take about twice as long to see the financial benefits than that of Project B. With this being the case, Project B is the better choice because of its larger NPV that is preferable when a business wants to see more timely capital gains. Factors of Consideration for Leasing and Buying Caladonia should consider several factors when deciding whether to lease or to buy. One important factor in the decision should be the net advantages of leasing (NAL). Advantages to leasing an asset can occur even if the net present value (NPV) for the purchase is negative ((Keown, Martin, Perry, Scott, 2005). The cost savings a company may experience on a lease may offset the negative NPV of a purchase (Keown, Martin, Perry, Scott, 2005). To determine the NAL, Caladonia will calculate the net present value of the lease option and compare it to the NPV of purchasing the product. Based on this calculation, if the NAL is positive, the leasing option would be preferred, if the NAL is negative then the purchase option should be selected. In addition to NAL, Caladonia should consider options such as the possibility of selling the equipment at the end of the project and receiving cash that would not be available if the company chooses to lease the merchandise. Another factor to consider is if the company has the cash to purchase the item, and operating expenses that may exist in purchasing that would not be the if the item were leased. Conclusion The new financial assistant at Caladonia has been challenged to determine which of two mutually exclusive projects would be the best decision for the company. Both projects estimate a rate of return of 11% and an initial investment of $100,000. Through the assistants analysis of each projects payback period, net present value, internal rate of return the determination has been made to accept project B and reject project A. Project B has the largest Net Present Value. The Net Present Value makes the most acceptable assumptions for the wealth- maximizing of the firm. References Keown, A. J. , Martin, J. D. , Petty, J. W. , Scott, S. F. (2005). Financial management: Principles and applications (10th ed. ). Upper Saddle River, NJ: Pearson/Prentice Hall.