BASICS OF CAPITAL BUDGETING You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler AG, Ford, Toyota, and other automakers. Your boss, the chief financial officer , has just handed you the estimated cash flows for two proposed projects. Project L 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 S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives because Allied is planning to introduce entirely new models after 3 years.
a. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions?
b. What is the difference between independent and mutually exclusive projects? Between projects with normal and non-normal cash flows?
c.
1. Define the term net present value (NPV). What is each project’s NPV?
2. What is the rationale behind the NPV method? According to NPV, which project(s) should be accepted if they are independent? Mutually exclusive?
3. Would the NPVs change if the WACC changed? Explain.
d.
