Caledonia

Financial Management: Principles and Applications

Week IV Team Assignment

Kristina Bury, Steven Leatherbury, Traci Russell, Jim Scanlon

Finance / 370

Derek Webster

June 20, 2011

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

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

The required rate of return on these projects is 11 percent.

See attached spreadsheet

a. What is each project’s payback period?

Project A- 100,000/32,000 = 3.125 years

Project B- 100,000/200,000 = 0.5 + 4 = 4.5 years

b. What is each project’s net present value?

Net Present Value Project A- $18,268.70

Net Present Value Project B- $18,690.27

c. What is each project’s internal rate of return?

Internal Rate of Return Project A- 18.03%

Internal Rate of Return Project B- 14.87%

d. What has caused the ranking conflict?

The conflicting rankings are caused by the reinvesting assumptions of the net present value (NPV) and the internal rate of returns (IRR). The NPV criteria assumes that cash flows over the life of the project can be reinvested at the required rate of return, and the IRR assumes the cash flows over the life of the project can be reinvested at the internal rate of return (Keown, Martin, & Petty, 2005.)

e. Which project should be accepted? Why?

Project B should be chosen because it has the largest net present value. This criterion has the best acceptable assumptions for the wealth of the shareholders. In the event that there is no capital rationing, the project with the highest NPV should be selected. (Keown, Martin, & Petty, 2005.)

References

Keown, A., Martin, J., & Petty, J. (2005). Financial Management: Principles and Applications. Retrieved from...