Mini Case (Chapter 10)

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.

his is a standard procedure for all new financial analysts at Caledonia, and it will 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 Analyst
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 Caledonia’s 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:

a. Why is the capital-budgeting process so important?
b. Why is it difficult to find exceptionally profitable projects?

c. 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?

d. What are the criticisms of the payback period?

e. Determine the NPV for each of these projects. Should either project be accepted?
f. Describe the logic behind the NPV.

g. Determine the PI for each of these projects. Should either project be accepted?

h. Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or
why not?
i. What would happen to the NPV and PI for each project if the required rate of return increased?
If the required rate of return decreased?