ASSIGNMENT (20 marks)

Deadline: 06.05.2023
Team Leader: ________
Team members: ______________________

Please answer the following questions:

1. Keyton LTD is a Canadian company that manufactures gutters for
residential houses. Its management believes it has developed a new
process that produces a superior product. The company must make an
initial investment of CAD190 million to begin production. If demand is
high, cash flows are expected to be CAD40 million per year. If demand
is low, cash flows will be only CAD20 million per year. Management
believes there is an equal chance that demand will be high or low. The
investment, which has an investment horizon of ten years, also gives
the company a production-flexibility option allowing the company to
add shifts at the end of the first year if demand turns out to be high. If
the company exercises this option, net cash flows would increase by an
additional CAD5 million in Years 2–10. Keyton’s opportunity cost of
funds is 10%.

The internal auditor for Keyton LTD has made two suggestions for
improving capital allocation processes at the company. The internal
auditor’s suggestions are as follows:

Suggestion 1: “In order to treat all capital allocation proposals in a fair

manner, the investments should all use the risk-free rate for the required
rate of return.”

Suggestion 2: “When rationing capital, it is better to choose the

portfolio of investments that maximizes the company NPV than the
portfolio that maximizes the company IRR.”

Answer the following questions: (14 marks)

 Q1: What is the NPV (CAD millions) of the original project for Keyton
LTD without considering the production-flexibility option? (2 marks)

NPV = -190 + ((40 × 0.5 + 20 × 0.5) / (1 + 01) ^ 10] = -190 + (30 / 2.5937) =
-CAD178.44 million

Q2: What is the NPV (CAD millions) of the optimal set of investment
decisions for Keyton LTD including the production-flexibility option? (6
marks)
Q3: Should the capital allocation committee accept the internal auditor’s
suggestions? Please explain why (6 marks)

Suggestion1: Internal auditor’s suggestion is that investments should be

evaluated with the risk-free rate for the required rate of return. It considers al
capital allocation proposals carry the same risk. However, that suggestion
couldn’t be true as reflected in the paper. Projects weigh various risks
depending on circumstances. In doing so, we consider the first suggestion
false.

Suggestion2: In the second one, we choose NPV method because compared

to IRR, NPV has more comprehensive approach to the profitability and takes
into consideration discount period and cost factors together.