- You recently went to work for a Components Company, a supplier of auto repair parts. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project 1 involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project 2 involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives because the company is planning to introduce entirely new models after 3 years. Here are the projects’ net cash flows:
|Year||Project 1||Project 2|
The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. The company’s required rate of return is 10%. You must determine whether one or both of the projects should be accepted.
- Compute each project’s payback and discounted payback period?
- What is the rationale for the payback method?
- According to the payback criterion, which project(s) should be accepted if the firm’s maximum acceptable payback is 2 years, if Projects 1 and 2 are independent, if Projects 1 and 2 are mutually exclusive?
- What are the two main disadvantages of discounted payback
- What is each project’s NPV?
- According to NPV, which project(s) should be accepted if they are independent?
- Explain the advantage of NPV.
- What is each project’s profitability index?
- According to the profitability index, which project(s) should be accepted if they are independent? Mutually exclusive?
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