Introduction to Finance

FIN 335: introduction to Finance
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Why is the capital- budgeting process so important?
Capital budgeting is important to determine the most optimal investment projects, and the management decides on long-term capital expenditures and strategic goals based capital budgeting analysis.
b. Why is it difficult to find exceptionally profitable projects?
In the competitive markets, firms are attracted to profitable industries driving down the profitability, and firms are unlikely to experience large profits in such markets (Keown, 2003). Firms rely on product differentiation, or a cost advantage approach, and this allows companies to support larger profits. In any case, it is easier to evaluate profitable projects than finding them (Keown, 2003).
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?
Project A
Payback period= 3 years+ (110,000-90,000)/ 50,000=3.4 years
Project B
Payback period= 2 years+ (110,000-80,000)/ 40,000= 2.75 years
Project B should be accepted as it has a shorter payback period less than the maximum acceptable payback period of 3 years, and it takes a shorter period of time to get the return on the initial investment.
d. What are the criticisms of the payback period?
The payback period does not take into account the time value of money, and ignores the other cash inflows after the initial investment has been recovered (Berry & Jarvis, 2013). As such, the approach does not measure profitability.
e. Determine the NPV for each of these projects. Should they be accepted?
Project A
=-$ 110,000+ (20,000/1.12)+(30,000/1.122)+(40,000/1.123)+(50,000/ 1.124)+(70,000/1.125)
= ($110,000) + $17,858+ $23,916 + $28,472+ $31,775+$39,718= $ 31,739
Project B
= initial outlay + cash flow* present value interests factor annuity
= ($110,000) + $40,000*3.6048= $34,192.
Both projects have a positive NPV, but project B should be accepted as it has a higher NPV.
f. Describe the logic behind the NPV.
The NPV approach uses discounted cash flows to determine the value of capital investments, and makes it easier to establish whether to maximize the value of these investments. In any case, the time value of money focuses on the opportunity costs of the investment projects. The NPV analysis is necessary to determine whether it is worthwhile to invest in projects, which increase the shareholder’s value, after recovering the costs and initial investments (Berry & Jarvis, 2013).
g. Determine the PI for each of these projects. Should they be accepted?
Profitability Index= PV of Future Cash Flows/ Initial Investment
Project A (PI) = $ 141,739/110,000= 1.2885
Project B (PI) = $ 144, 192/ 110,000= 1.3108
Project B has a higher profitability index at 1.3108, which is higher than the minimum acceptable index of 1.0 where the project PV is equal to the initial investment.
h. Would you expect the NPV and PI methods to give consistent accept/ reject decisions? Why or why not?
The NPV and PI approaches are associated with the same accept/ reject decisions since when the NPV is positive, the PI is above 1.0 whe...