Part 1
Assume that for a car manufacturer, Chrysler Ford. 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 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 Chrysler is planning to introduce entirely new models after 3 years.
Here are the projects net cash flows (in thousands of dollars):
Expected after-tax
net cash flows (CFt) Project S
Year (t) Project S Project L 0 1 2 3
0 ($100) ($100) -100 70 50 20
1 70 10
2 50 60 Project L
3 20 80 0 1 2 3
-100 10 60 80
Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.
The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk
characteristics which are similar to the firm’s average project. Chrysler’s weighted average cost of capital is 10%.
You must now determine whether one or both of the projects should be accepted.
Required
Evaluate the projects using the 5 key techniques:
(1) payback period,
(2) discounted payback period,
(3) net present value,
(4) internal rate of return, and
(5) modified internal rate of return.
Identify those projects that will lead to the maximization of the firm’s stock price.
Part 2
Critically appraise the appraisal techniques above. Discuss their limitations, the social and
ethical factors that should also be considered when making such decisions.
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