Part 4 Ch 06

# Part 4 Ch 06 - CHAPTER 6 INTEGRATIVE PROBLEM 6-12 A YOUR...

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CHAPTER 6 INTEGRATIVE PROBLEM ANSWER : Capital budgeting is the process of analyzing additions to fixed assets . Capital budgeting is important because, more than anything else, fixed asset investment decisions chart a company’s course for the future. Conceptually, the capital budgeting process is identical to the decision process used by individuals making investment decisions. These steps are involved: (1) Estimate the cash flows —interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects. (2) Assess the riskiness of the cash flows. (3) Determine the appropriate discount rate , based on the riskiness of the cash flows and the general level of interest rates. This is called the project’s required rate of return, or cost of capital, in capital budgeting. (4) Find (a) the PV of the expected cash flows and/or (b) the asset’s actual rate of return . (5) If the PV of the inflows is greater than the PV of the outflows (the NPV is positive), or if the calculated rate of return (the IRR) is higher than the project cost of capital, accept the project. 96 6-12 YOUR BOSS, THE CHIEF FINANCIAL OFFICER (CFO) FOR SOUTHERN BUILD UP THE MARKET FOR THIS PRODUCT, SO THE CASH INFLOWS WOULD INCREASE OVER TIME. PROJECT S INVOLVES AN ADD-ON TO AN EXISTING LINE, AND ITS CASH FLOWS WOULD DECREASE OVER TIME. BOTH PROJECTS HAVE THREE-YEAR LIVES BECAUSE SOUTHERN IS PLANNING TO INTRODUCE AN ENTIRELY NEW FABRIC AT THAT TIME. HERE ARE THE NET CASH FLOW ESTIMATES (IN THOUSANDS OF DOLLARS): EXPECTED NET CASH FLOWS YEAR PROJECT L PROJECT S 0 (\$100) (\$100) 1 10 70 2 60 50 3 80 20 THE CFO ALSO MADE SUBJECTIVE RISK ASSESSMENTS OF EACH PROJECT, AND HE CONCLUDED THAT THE PROJECTS BOTH HAVE RISK CHARACTERISTICS THAT ARE SIMILAR TO THE FIRM’S AVERAGE PROJECT. SOUTHERN’S REQUIRED RATE OF RETURN IS 10 PERCENT. YOU MUST NOW DETERMINE WHETHER ONE OR BOTH OF THE PROJECTS SHOULD BE ACCEPTED. START BY ANSWERING THE FOLLOWING QUESTIONS: A. WHAT IS CAPITAL BUDGETING? ARE THERE ANY SIMILARITIES BETWEEN A FIRM’S CAPITAL BUDGETING DECISIONS AND AN INDIVIDUAL’S INVESTMENT DECISIONS?

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ANSWER : Projects are independent if the cash flows of one are not affected by the acceptance of the other. Conversely, two projects are mutually exclusive if acceptance of one impacts adversely the cash flows of the other; that is, at most one of two or more such projects can be accepted. Put another way, when projects are mutually exclusive it means that they do the same job. For example, a forklift truck versus a conveyor system to move materials, or a bridge versus a ferry boat. Projects that have conventional cash flows have outflows, or costs, in the first year (or years) followed by a series of inflows. Projects with unconventional cash flows have one or more outflows after the inflow stream has begun. Here are some examples: Inflow (+) or Outflow ( - ) in Year 0 1 2 3 4 5 Conventional - + + + + + - - + + + + - - - + + + Unconventional - + + + + - - + + - + - + + + - - - ANSWER : The payback period is the expected number of years required to recover a project’s cost.
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