ADMS 1500 Lecture Notes - Lecture 10: Discounted Cash Flow, Capital Budgeting, Net Present Value
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The conference on evaluating capital projects has been very helpful. You have received a significant amount of information and multiple projects to evaluate to hone your skills. To adequately teach Grammy and the board you will need to answer several questions about the capital-budgeting process. You will do this in a business memo that is no more than four pages long.
Provide an evaluation of two proposed project, both with a 5-year expected lives and identical initial outlays of $110,000. Both of these projects involve additions to a highly successful 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 question:
Why is the capital-budgeting process so important?
Why is it difficult to find exceptionally profitable projects?
What is the payback period on each project? If the organization imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?
What are the criticisms of the payback period?
Determine the NPV for each of these projects. Should they be accepted?
Describe the logic behind the NPV.
Determine the PI for each of these projects. Should they be accepted?
Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
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?
Determine the IRR for each project. Should they be accepted?
How does a change in the required rate of return affect the project’s internal rate of return?
What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?
| FILL IN THE CORRECT TERMINOLOGIES IN THE BLANK SPACES | ||
| _____ 1. | a. A method of internal (managerial accounting) reporting that emphasizes the distinction between variable and fixed costs. | |
| _____ 2. | b. A discounted cash flow approach to capital budgeting that computes the present value of all future cash flows. | |
| _____ 3. | c. Determination of the maximum cost a company can spend to make a product given a set volume, selling price and desired operating profit. | |
| _____ 4. | d. An analysis of the additional costs and benefits of a proposed alternative compared with the current situation. | |
| _____ 5. | e. A historical cost that the company has already incurred which is irrelevant to the decision making process. | |
| _____ 6. | f. Costs that will not continue if an ongoing operation is changed or deleted. | |
| _____ 7. | g. An already owned production site that is not currently in use. | |
| _____ 8. | h. The maximum available benefit foregone by using a resource for a particular purpose. | |
| _____ 9. | i. The predicted future costs and revenues that will differ among alternative courses of action. | |
| _____ 10. | J. The time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project | |
| _____ 11. | k. Those costs of facilities and services that are shared by users | |
| _____ 12. | l. The juncture of manufacturing where separate products developed in the same process become individually identifiable. | |
| _____ 13. | m. A costing approach that considers all indirect manufacturing costs (both variable and fixed) to be product (inventoriable) costs. | |
| _____ 14. | n. Purchasing products or services from a supplier outside the company. | |
| _____ 15. | o. Capital budgeting models that focus on cash inflows and ouflows while taking into account the time value of money | |
| _____ 16. | p. Calculation of a selling price sufficient to cover the cost of producing a product as well as desired operating income | |
| _____ 17 | q. The long-term planning for investment commitments with returns spread over multiple years | |
| _____ 18. | r. A decision process that compares the differential revenues and costs of alternatives. | |
| _____ 19. | s. Costs that will continue even if a company discontinues one of its current operations | |
| _____ 20. | t. The increase in expected average annual operating income divided by the original required investment | |
