You are evaluating two possible projects for your company, both of which involve the development of a new kind of computer mouse. The projects are mutually exclusive, meaning that the company can invest in only one of them. Both projects require an initial investment of $32 million to be made in each of the next three years. Sales and profits will begin in the 4th year, and this is where the two projects differ. Version A, which is more innovative, is expected to have sales in year 4 of $24 million and cash profits of $7.8 million. Profits are expected to increase 6% annually. Version B, which is less innovative but cheaper to produce, is expected to have the same sales in year 4, but profits of $8.9 million. Profits for version B are expected to increase only 4% annually. Assume for simplicity that all cashflows occur at the end of the year. The cost of capital for both projects is 12%. a) Which is the better project? How much is each project worth? b) You have the opportunity to increase the growth rate of project B to 6%. How much would you be willing to invest (today) to get this higher growth? c) You are not sure that the discount rate is really 12%. What happens to the value of each project if the discount rate rises to 14% or falls to 10%? Which project is more sensitive to changes in r? Why?
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
Question Two
You are evaluating two possible projects for your company, both of which involve the development of a new kind of computer mouse. The projects are mutually exclusive, meaning that the company can invest in only one of them. Both projects require an initial investment of $32 million to be made in each of the next three years. Sales and profits will begin in the 4th year, and this is where the two projects differ. Version A, which is more innovative, is expected to have sales in year 4 of $24 million and cash profits of $7.8 million. Profits are expected to increase 6% annually. Version B, which is less innovative but cheaper to produce, is expected to have the same sales in year 4, but profits of $8.9 million. Profits for version B are expected to increase only 4% annually. Assume for simplicity that all cashflows occur at the end of the year. The cost of capital for both projects is 12%.
a) Which is the better project? How much is each project worth?
b) You have the opportunity to increase the growth rate of project B to 6%. How much would you be willing to invest (today) to get this higher growth?
c) You are not sure that the discount rate is really 12%. What happens to the value of each project if the discount rate rises to 14% or falls to 10%? Which project is more sensitive to changes in r? Why?
Step by step
Solved in 5 steps with 8 images
